Understanding the diagonal spread option strategy

Construction: how to build a diagonal spread

We’ve talked about what a diagonal spread is and now its time to think about the fundamental variables to consider when building one.

1. Define your market outlook

• If you’re bullish, a bull call diagonal or bull put diagonal should be implemented.
• If you’re bearish, a bear put diagonal or bear call diagonal should be implemented.

2. Choose the option type (calls or puts)

• Calls should be used when you expect the asset to rise.
• Puts should be used these when you expect the asset to fall.

3. Select the strike prices

• When using a long option (farther expiry) a strike price close to the current market price (ATM) should be chosen to gain directional exposure.
• When using a short option (nearer expiry) a higher strike (for calls) or a lower strike (for puts) should be used to collect premium income.

4. Pick expiration dates

• Longer-term options (1–6 months out) provide sustained exposure to price movements.
• Shorter-term options (2–6 weeks out) generate income from time decay (theta).

5. Decide between buying or selling a diagonal spread

• Buying a diagonal spread (net debit) is suitable when you expect a gradual move in the expected direction.
• Selling a diagonal spread (net credit) is useful when you anticipate minimal price movement and want to profit from time decay.

Timing: when to enter a diagonal spread

Before an event

A bought diagonal spread allows you to benefit from potential price movements after an event, such as the release of an earnings report or Federal Reserve announcement. The longer-term option retains both intrinsic and extrinsic value, keeping the trade viable even after the catalyst.

After an event

A sold diagonal spread can take advantage of declining implied volatility (IV). The shorter-term option benefits from accelerated time decay, making this approach attractive after major events.

Choosing the right diagonal spread

How to decide between a call or put diagonal?

When selecting a diagonal spread, the choice between a call or put strategy depends on market expectations and implied volatility (IV) conditions. Below is a summary of the preferred spread for different market scenarios:

• Bullish with high IV = Bull put diagonal (credit spread)
• Bullish with low IV = Bull call diagonal (debit spread
• Bearish with high IV = Bear call diagonal (credit spread)
• Bearish with low IV = Bear put diagonal (debit spread)

Strike selection based on market movement

If you expect gradual movement, use at-the-money (ATM) strikes for steady gains, or if you expect significant movement, use out-of-the-money (OTM) long strikes to capture larger price swings.

Example: using a diagonal spread in the S&P 500 (ES) futures market

Suppose the S&P 500 is trading at 4,800, and you expect a moderate-bullish move over the next 2–3 months, you can set up a bull call diagonal spread trade by following three steps.

1. Buy a longer-term call option

• Buy an ES 4,800 call expiring in 3 months for a USD 50 premium.

2. Sell a shorter-term call option

• Sell an ES 4,900 call expiring in 1 month for a USD 20 premium.

3. Net cost of the trade (debit spread)

• USD 50 (long call) – USD 20 (short call) = USD 30 net debit

Profit and risk analysis

• Maximum profit is achieved if ES trades just below 4,900 at the short option’s expiration, meaning that the short call expires worthless while the long call retains value.
• Maximum loss is limited to the USD 30 debit paid.
• Break-even price is adjusted for time decay and premium collected.

Pros and cons of diagonal spreads

A diagonal spread offers several advantages to traders, as well as certain risks and limitations.

Advantages

• Directional exposure with a time advantage. The longer-dated option benefits from sustained price movements.
• Defined risk. The maximum possible loss is the initial debit paid.
• Theta advantage. The shorter-term option generates income from time decay, reducing overall cost.
• Volatility flexibility. Can be structured to take advantage of shifts in implied volatility (IV).

Disadvantages

• Complexity. Requires active monitoring and potentially rolling the short option.
• Liquidity risk. Wide bid-ask spreads can impact trade execution, especially for illiquid options.
• Directional risk. If the asset moves too far, the long option may not gain as expected, reducing potential profits.

Greeks, skew, and market considerations

In a diagonal call spread, understanding the Greeks, skew and kurtosis is important for effective strategy management.

• Delta (Δ). Measures the rate of change in an option’s price and adjusts dynamically, increasing as the short option nears expiration.
• Gamma (Γ). Indicates the rate of change in delta and becomes more sensitive as the short leg nears expiry.
• Theta (Θ) Represents time decay. Theta is positive if structured as a net credit spread or negative if structured as a net debit spread.
• Vega (ν). Measures the sensitivity of an option’s price to changes in the volatility of the underling asset. In a diagonal spread, vega is generally higher for a longer-term option, making the strategy sensitive to changes in IV.
• Rho (ρ). Assesses the impact of interest rate changes on the option’s price. This is more of a consideration when trading long-dated options.

When using the diagonal call spread strategy, it is important to consider implied volatility skew. Shorter-term options often have higher implied volatility, which directly affects premium pricing.

Additionally, kurtosis and event risk should be taken into account. A higher kurtosis, or the presence of fat tails in a price distribution, suggests a greater likelihood of extreme price movements, which could impact the strategy’s profitability.

Why use a diagonal spread?

A diagonal spread allows traders to balance short-term flexibility with long-term potential, much like leasing a new car while still owning the current one. This strategy is most effective when a gradual price movement is expected rather than sharp fluctuations, when there is a desire to gain exposure to changes in implied volatility, or when the goal is to generate theta decay income while maintaining some directional exposure.

By carefully selecting strike prices, expiration dates, and market conditions, traders can customise diagonal spreads to match their market outlook, managing both risk and reward effectively.