Diagonal Spread Options: Definition, Strategy, Examples

What Is a Diagonal Spread?

A diagonal spread represents a sophisticated trading strategy employed by seasoned market participants. It entails concurrently buying and writing two contracts with distinct grant prices and maturity dates on the same base asset, such as Bitcoin. The technique is called a "diagonal spread" since the profit and loss profile of the position resembles a diagonal line when plotted on a graph. This versatile strategy allows market players to profit from fluctuations in the price of the base asset and the theta decay of the derivative contracts.

Key Takeaways

• Diagonal spreads entail buying and writing derivatives with different exercise prices and expiry dates.
• The strategy can be employed to capitalize on moderate price movements in the base cryptocurrency and changes in implied volatility levels.
• Diagonal spreads can be constructed with the use of either calls or puts, depending on the investor's market perspective and their appetite for risk.
• The earnings capacity of the strategy is influenced by the distinction in exercise prices and maturity dates of the options involved.
• The strategy under consideration is best suited for experienced market participants with a solid comprehension of derivative trading and a moderate risk appetite.

Diagonal Spread Strategy: How It Works

A diagonal debit spread technique is created by buying an option with a longer expiry date and selling a contract with a shorter expiry date on the same base crypto asset. The bought contract typically has a higher exercise price for calls or a lower exercise price for puts than the sold one.

The main purpose of this strategy is to increase the value of the long-term option when the price of the base cryptocurrency increases. Another goal is to compensate for the value of the position with the premium received from the sale of the short-term option.

This creates a position with a limited risk profile and the potential to profit from fluctuations in the price of the base asset and the theta decay of the derivative contract.

Diagonal Spread Types

This strategy can be constructed using either calls or puts, depending on the investor's market outlook and risk tolerance. There are two main types of diagonal options technique:

1. Long Call Diagonal Spread. This type entails buying a longer-dated call with a higher exercise price and writing a shorter-dated call option with a lower exercise price. It is typically used when the market participant expects the base asset's price, such as Bitcoin, to rise moderately over time.

2. Long Put Diagonal Spread. The second type is opposite to the first one in terms of the class of options and exercise prices. In this case, you are buying a longer-dated put with a lower exercise price and writing a shorter-dated put option with a higher exercise price. It is typically used when the market participant expects the base asset's price to decline moderately over time.

Long Call Diagonal Spread Setup

To set up a long call diagonal spread, a market participant can follow these steps:

1. Choose a base cryptocurrency, such as Bitcoin. Let’s take for example a current price of $20,000.
2. Buy a longer-dated call contract on the base asset with a strike price above the current price. For instance, buy a call with an exercise price of $21,000 and an expiry date three months out.
3. Sell a shorter-dated call on the same base asset with an exercise price below the exercise price of the purchased contract. For instance, sell a call contract with an exercise price of $20,500 and an expiry date one month out.

Long Put Diagonal Spread Setup

To set up a long put diagonal spread, an investor can follow these steps:

1. Choose a base asset, such as Bitcoin. Again, as in the example above we take a current price of $20,000.
2. Buy a longer-dated put option on the base asset with an exercise price below the current price. For instance, buy a put contract with an exercise price of $19,000 and an expiry date three months out.
3. Sell a shorter-dated put on the same base asset with an exercise price above the strike price of the purchased contract. For instance, sell a contract with an exercise price of $19,500 and an expiry date one month out.

Diagonal Spreads for Trading Earnings

Diagonal spreads can be effective around earnings announcements when investors expect a price move in the base asset and changes in implied volatility.

Earnings releases frequently bring increased volatility as market participants respond to the freshly disclosed data. Diagonal spreads stand to gain from shifts in implied volatility, particularly when a long option has more time until maturity. Consequently, this may cause the long option's value to appreciate, possibly yielding a favorable return.

Diagonal Spread Profit and Loss

Several factors can impact the profit and loss potential of a diagonal spread. They include the distinction in exercise prices and expiry dates of the contracts involved, as well as the price movement and implied fluctuation of the base asset price.

Profit Potential

The maximum profit potential of a diagonal spread occurs when the price of the base cryptocurrency is equal to the exercise price of the sold option at its maturity date. In this scenario, the sold derivative contract expires uselessly, while the purchased option retains its value or rises in value due to the price movement of the base asset.

Loss Potential

Speaking of the maximum loss potential, it is limited to the net premium paid for the position. Let’s say the base asset's price is below the exercise price of the purchased call or above the exercise price of the bought put at expiration. In this scenario, both contracts expire worthless, and the investor incurs a loss equal to the net premium paid.

Breakeven Point

The breakeven point for a diagonal spread is the base asset's price at which the net profit or loss from the position is zero. The breakeven point can be calculated by adding (for a long call diagonal spread) or subtracting (for a long put) the net premium paid from the exercise price of the purchased option.

Long call diagonal spread breakeven point = Long call strike price + Net debit paid

Long put diagonal spread breakeven point = Long put exercise price - Net debit paid

Diagonal Spread Strategy Sweet Spot

The sweet spot for a diagonal spread is the price point at which the position generates the maximum income potential.

For Diagonal Spread Call Strategy

For a long call diagonal spread, the sweet spot is when the base asset's price is equal to or slightly above the exercise price of the sold call at its expiry date.

For Diagonal Spread Put Strategy

For a long put diagonal spread, the sweet spot is when the base asset's price is equal to or slightly below the exercise price of the sold put contract at its expiry date.

Diagonal Spread Example

Let's consider an investor who expects Bitcoin's price to rise moderately over the next three months. In this example, we’ll assume that the current value of Bitcoin is $20,000. The long call diagonal spread will be implemented in the following steps:

1. Purchasing a call contract on Bitcoin with a strike price of $21,000 and a maturity date three months out for a premium of $1,500.
2. Selling a call on Bitcoin with an exercise price of $20,500 and an expiry date one month out for a premium of $800.

The net cost of entering this long call diagonal position is $700 ($1,500 - $800). The max loss potential is limited to the net premium paid ($700).

To determine the maximum possible gain in this case, we need to consider the outcome at the maturity date of the sold call option (one month out). Let's assume Bitcoin's price is equal to the strike price of the sold call ($20,500) at its maturity date. In this scenario, the sold call with a strike price of $20,500 expires uselessly, and the investor keeps the entire premium of $800.

As for the purchased call option with an exercise price of $21,000 and an expiry date in three months, it will still have a time value because it has not yet expired. Let's assume the time value at maturity of the purchased call option is $1,000 and the trader decides to close the position by selling it.

The maximum possible profit is the sum of these two components minus the net cost of entering the long call diagonal position:

Maximum profit = Value of a long call on the expiry date of a short call option - Purchase price of a long call + Premium from the sale of a short call option

Max Profit = $1000 - $1500 + $800

Max Profit = $300

So, the maximum possible profit for this long call diagonal spread in this case is $300.

Diagonal Spread Tips

Be Careful Not to Overpay.

When implementing a diagonal spread, make sure you're not overpaying for the options involved. High premiums can reduce your potential profit and increase your risk exposure.

Use the Mini Diagonal

A mini diagonal spread technique involves using derivatives with smaller differences in exercise prices and expiry dates. This approach can help limit risk and reduce the impact of time decay on the position.

Make Adjustments in Bearish Markets

In bearish markets, consider adjusting your diagonal spread positions by rolling down the sold options to lower strike prices or rolling out the purchased contracts to later expiry dates. This can help manage risk and potentially increase profit potential.

Maximum Take-Profit Potential

The maximum take-profit potential for a diagonal spread is reached when the base asset's price is equal to the exercise price of the sold option at its expiry date. In this scenario, the sold contract expires worthless, while the purchased contract retains its value or rises in value due to the price movement of the base asset. The exact profit amount depends on the net premium paid for the position and the distinction in exercise prices of the contracts involved.

Maximum Incurred Loss Potential

One of the benefits of employing a diagonal spread is the limited maximum loss potential. If the base asset's price drops below the strike price of the purchased call or rises above the strike price of the purchased put, both contracts expire worthless. In this scenario, an investor incurs a loss equal to the net premium paid.

Margin Requirements

Margin requirements for diagonal spread positions vary depending on the exchange and the specific options involved. Generally, the margin requirement for a diagonal spread is equal to the net premium paid for the position plus any additional margin required for the sold contract. Some exchanges may also require additional margin for potential losses associated with the purchased contract.

Theta Decay Impact

Theta decay, or time decay, is the decline in the value of an option as it approaches its expiry date.

In a diagonal spread, the impact of theta decay is generally positive, as the sold option with a shorter expiry date experiences a more rapid decline in value than the purchased contract with a longer expiry date. This difference in time decay can help increase the profit potential of the position.

Implied Volatility Effect

Implied volatility (IV) represents the market's expectation of the future fluctuation of the base asset price. Changes in IV can significantly impact the value of the options involved in a diagonal spread.

Ordinarily, an rise in IV benefits the long diagonal call spread as well as the long diagonal put spread. However, investors should keep an eye on changes in IV and be prepared to adjust their positions accordingly.

Diagonal Spread vs. Calendar Spread vs. Vertical Spread

Diagonal, calendar, and vertical spread all share similar characteristics and that is why may leave novice investors confused.

The main focus of our article, a diagonal spread, entails buying and writing derivatives with distinct exercise prices and time of expiry. The other two strategies involve options with the same maturity dates or strike prices:

1. A calendar spread, sometimes referred to as a horizontal spread, entails buying and writing options with the same exercise price but different maturity dates.
2. A vertical spread entails buying and writing derivatives with different exercise prices but the same expiry date.

Each of these strategies has its own unique risk and reward profiles, and the best choice depends on the market participant's market outlook, risk tolerance, and trading objectives.

Who Can Use the Diagonal Spread Technique?

It is worth noting that this strategy is best suited for experienced derivative traders with a solid understanding of options trading concepts and a moderate risk appetite. Diagonal spread requires the ability to analyze various factors, including the Greeks, implied volatility, and the base asset's price movement, to make informed decisions about position management and adjustments.

When to Use a Diagonal Spread Strategy

A diagonal spread may be employed in cases when a market participant expects a moderate price movement in the base cryptocurrency and changes in IV. The strategy can also be effective for trading during financial report releases or other market events that could impact the price of the base asset and IV.

Benefits

• Limited risk exposure: the greatest loss potential of a diagonal spread is limited to the net premium paid for the position.
• Profit potential: the strategy offers the potential for profit from both price fluctuation in the base asset and changes in IV.
• Flexibility: the strategy can be constructed using either calls or puts, depending on the investor's market outlook and risk tolerance.

Cons

• Complexity: diagonal spreads are more complex than some other trading strategies and require a strong comprehension of options trading concepts.
• Limited profit potential: the profit potential of the technique is limited by the difference in exercise prices and expiry dates of the contracts involved.
• Active management: the strategy may require active management and adjustments to maximize income potential and manage risk effectively.

Risks

• Loss of net premium paid : if the base asset's price does not move as anticipated, the investor may lose the net premium paid for the position.
• Changes in implied volatility : unexpected changes in IV can negatively impact the value of the contracts involved in a diagonal spread, potentially reducing income potential or increasing losses.
• Time decay: although the impact of time decay can be beneficial for diagonal spreads, if the base asset's price remains stagnant and IV does not change as expected, the investor may experience losses due to time decay.

Conclusion

Diagonal spread that we discussed in this material is a versatile and potentially profitable options trading technique for experienced market participants with a moderate risk appetite. By buying and writing derivative contracts with distinct prices and expiry dates, investors can profit from moderate price movements in the base asset and changes in implied volatility. However, the strategy requires a strong comprehension of options trading concepts and active position management to maximize profit potential and manage risk effectively.

Frequently Asked Questions (FAQs)

Is a Diagonal Spread Profitable?

This strategy can be profitable if the base asset's price moves as anticipated and IV changes favorably. The profit potential is influenced by the distinction in exercise prices and expiry dates of the derivative contract involved and the net premium paid for the position.

How Do You Close a Diagonal Spread?

To close a diagonal spread position, an investor must concurrently buy back the sold option and sell the purchased contract. This can be done through a closing transaction in the derivative market, typically using a limit order to specify the desired price for each contract.

Is Diagonal Spread Better Than Credit Spread?

The strategy under consideration and credit spreads are different strategies with their own unique risk and reward profiles. The best choice between the two depends on the investor's market outlook, risk tolerance, and trading objectives. Diagonal spreads offer the potential for profit from both price fluctuation in the base asset and changes in IV, while credit spreads primarily income from the theta decay of contracts.

What Is a Diagonal Call Spread

A diagonal call spread is essentially a diagonal spread that includes positions in calls. One call is bought, and another one is sold to form the strategy. The calls have distinct exercise prices and times of expiry.

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