Overview of Diagonal Spreads
One of the widely used methods for categorizing options spreads is to classify them based on direction. In this respect, they can fall into one of the three following categories: vertical, horizontal and diagonal spreads. Diagonal spreads consist of similar options contracts in that they must be of the same type and based on the same underlying security, but the contracts involved have different expiration months and different strike prices.
On this page we offer further information about how you can create diagonal spreads and exactly what you would use them for in your trading.
We should point out that diagonal spreads are also a form of calendar spreads. Not all calendar spreads are diagonal though, so you should understand the distinction of exactly what the characteristics of a diagonal spread are. This page has been primarily written to give something of an overview on this particular type.
As each type of spread is essentially a specific trading strategy in itself, to truly understand how you can utilize them you should take the time to read our section on Options Trading Strategies. This section explains all the different types and the best methods and times for using them.
Creating Diagonal Spreads
To create a diagonal spread you need to use two different types of options order: the sell to open order to write options contracts, and the buy to open order to purchase options contracts. You would first write contracts, and then buy contracts of the same type and on the same underlying security, but with a later expiration date and a different strike price. You can create them using calls or puts.
Diagonal spreads are essentially a combination of vertical and horizontal spreads. They combine the different strike price feature of the vertical spread and the different expiration date feature of the horizontal spread. They are known as such because the contracts involved appear diagonally from each other in an options chain. If you do not know what an options chain is and the role it has to play, then please read our page on them for full details.
Advantages & Disadvantages
The main purpose of diagonal spreads is essentially to profit from time decay. Short term options contracts generally experience a faster rate of time decay than long term options contracts, so by writing short term contracts and buying long term contracts you can potentially make a return from these differing rates of time decay. Where they have the advantage over horizontal spreads is that the differing strike prices also provide a larger potential for profits based on movements in the price of the underlying security.
The main advantages are that the contracts you buy reduce the margin requirement for the contracts you sell. You can also offset some of the potential losses of the contracts you have written with the ones you have sold. The differing strike prices also give you the potential for a higher return on investment than horizontal spreads do.
The biggest disadvantages are that you are making multiple trades, and as such will spend more in commissions, and you are also limiting potential profits as well as limiting potential losses.