What is a Diagonal Spread in Options?
A diagonal spread is an options trading strategy that involves buying and selling options contracts with different strike prices and expiration dates. This strategy combines elements of both vertical spreads and horizontal spreads, hence the name “diagonal.”
How Does a Diagonal Spread Work?
In a diagonal spread, an investor typically buys a long-term option contract with a later expiration date and sells a short-term option contract with a closer expiration date. These options contracts have different strike prices, with the long-term option having a strike price higher than the short-term option.
The goal of a diagonal spread is to profit from the time decay of the short-term option while still benefiting from directional moves in the underlying asset. This strategy is often used when the investor expects the underlying asset to have a gradual and steady movement towards the strike price of the long-term option.
Example of a Diagonal Spread
Let’s say you have a bullish outlook on a particular stock and you want to implement a diagonal spread strategy. You could buy a call option with a strike price of $50 that expires in six months (long-term option) and simultaneously sell a call option with a strike price of $55 that expires in one month (short-term option).
If the stock price gradually increases and approaches the $55 strike price by the time the short-term option expires, you would profit from the time decay of the short option while still benefiting from the price increase of the stock.
By Astrobulls research pvt ltd