What is a Diagonal Spread, and How Does It Work?

In options trading, diagonal spread refers to a trade that is characterized similarly to both vertical spreads and calendar spreads offering traders a chance to maximize profits in the course of minimizing risk. Diagonal spread is the strategy in which an option on the same underlying asset with different strike prices and expiration dates is both bought and sold at the same time. It provides the trader with the opportunity to exploit many types of conditions prevailing in the market. Diagonal spreads, in particular, may be very effective in the given context because of the specific features of the Indian stock market as compared to other similar markets of the world.

A bullish diagonal spread is a strategy of trading a longer-term call option simultaneously with the selling of a shorter-term call option with a higher strike price. A bearish diagonal put spread involves going long a put at a higher expiration and short a lower striking put option at the same price and at a closer expiration. This strategy is quite helpful for the Indian traders because simple examples show how such spread can be designed to signal and take advantage of a particular market situation, and therefore it can be one of the mighty weapons in a trader’s hand.

What Constitutes a Diagonal Spread?

A diagonal spread is a trade strategy where a trader simultaneously purchases and sells options of exactly the same quantity, but at various strike price and with diverse expiry dates. It is characterized by the following attributes:

• Strike Price Variance: The options involved also have different strike prices.
• Expiration Date Variance: The options have different expiry dates usually the longer expiry date and the shorter expiry date.

This strategy is very favourable to individuals who seek to take advantage of both time and changes in volatility while anticipating a price movement in the underlined asset.

How to Construct a Diagonal Spread?

Constructing a diagonal spread involves knowledge with regard to the movement of the underlying asset as well as the time value of options. Here’s a step-by-step approach to building this strategy:

1. Select the Underlying Asset: Select shares or index that you are aware of and think will be either moving up and down or generally inclined in a certain direction.
2. Choose the Options:

          Buy a Longer-Dated Option: This should have a relatively longer time till the expiry and is generally bought at a higher strike price.

          Sell a Shorter-Dated Option: This ought to be closer to its expiration and can be bought on a higher or lower strike price consistent with the trader’s viewpoint towards a certain market.

1. Determine Strike Prices: The strike prices should be chosen based on your convection about the underlying asset. One of the strategies is when a short-term call option is chosen with a strike price that is a little higher than the current market price of the underlying security.
2. Analyze the Premiums: Get the premiums of the two bought and sold options to make sure that it is worth it. Successful innovation positions a venture where there is minimal investment required to break into a market, balanced against the greatest possible profit that can be made at that level.
3. Monitor the Position: Lastly, ensure that the position is taken, and search for signs that will show either an increase in volatility or a shift in the basic stocks or options market direction.

Different Variations of Diagonal Spreads

Diagonal spreads can be categorized into various types based on the options involved:

1. Diagonal Call Spread: This consists of going long in a call option that has a long time to expiration, and going short in a call, which has a short time to expiration, and whose strike price may be higher or lower than the first. This is useful when you expect prolonged bullish status on the underlying asset since you are always holding the options.
2. Diagonal Put Spread: This involves purchasing of a put option that is expiring much later and disposing an early expiring put option. This is ideal for those traders who believe that the market is headed south in terms of the underlying asset.
3. Diagonal Call and Put Spread Combination: There can also be the case where a trader uses both calls and puts this will help him or her have flexibility depending on his or her prediction on the market.

Configurations of Diagonal Calendar Spreads

The diagonal calendar spread is a specific type of diagonal spread that aims at making the best use of the time decay factor. This strategy typically involves the following configurations:

• Longer-Dated Options: If you enter into a buying data relationship with a call or put, then that necessarily means the option has a long duration.
• Shorter-Dated Options: Exercise by relinquishing a call or put option that has been sold with a however short time until its expiration.
• Strike Price Selection: The strike prices can be equal or unequal to each other depending with the trader’s expectation of the underlying asset.

Diagonal Calendar Spread: An Example

Suppose we have a stock today that costs ₹1,000.• Own a call option of ₹1,050 strike price that expires in the value of three months at a price of ₹40.• Short a call option with the strike price of ₹1,100 and with expiration of one month at a price of ₹20.ime decay advantage. This strategy typically involves the following configurations:

• Longer-Dated Options: Buying a call or put option with a longer expiration date.
• Shorter-Dated Options: Selling a call or put option with a shorter expiration date.
• Strike Price Selection: The strike prices can be the same or different, depending on the trader’s view of the underlying asset.

Example of a Diagonal Calendar Spread

Consider a stock currently trading at ₹1,000. A trader might:

• Invest in a call option at ₹1,050 by paying ₹40 for a call option that will expire in the next three months.
• Write a call option Call option for a ₹1,100 strike price in one month at a premium of ₹20.

In this case, the net cost of the diagonal spread is ₹20 ($0.40- $0.20) and the trader make a profit on two positions; the selling of the option, being the write option; and the bull spread, where he is waiting for the stock price to rise.

Practical Illustration of a Diagonal Spread

To illustrate the working of a diagonal spread, let’s consider the following example:

Assumptions:

• Current stock price of the underlying asset: ₹1,200
• Long call option purchased with a strike price of ₹1,250 (expiry in three months) at a premium of ₹50.
• Short call option sold with a strike price of ₹1,300 (expiry in one month) at a premium of ₹25.

Calculating the Cost of the Diagonal Spread:

Option Type	Strike Price	Premium (₹)	Net Cost (₹)
Long Call	₹1,250	₹50
Short Call	₹1,300	₹25
Total Cost			₹25 (₹50 – ₹25)

Profit and Loss Scenarios

Profit Scenarios:

• If the stock price rises above ₹1,300 by expiration of the short call, the trader profits from the long call option while incurring a loss on the short call.
• If the stock price is between ₹1,250 and ₹1,300 at expiration, the trader benefits from the time decay of the sold option.

Loss Scenarios:

• If the stock price remains below ₹1,250 at expiration, both options may expire worthless, resulting in a loss equal to the net cost of ₹25.

Conclusion

Altogether, diagonal spreads are a powerful and well-planned plan in options trading for which Indian investors can opt whenever the market becomes volatile. Diagonal spreads are foundational in options trading. Mastering strategies like the diagonal bear call spread and understanding their variations can significantly enhance portfolio performance while managing risk.

Like any other trading strategy, it is important to do your homework, analyze, and constantly monitor the market to take advantage of the opportunities offered by diagonal spreads. But by adding this strategy to its set of tools, one can prepare for the contingent that arises within the constantly evolving Indian stock market.

• Author: Religare Broking
• Last Updated: November 26, 2024