Diagonal Spreads Explained

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Diagonal Spreads Explained

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Long diagonal spread with calls

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Potential goals

  1. To profit from neutral stock price action near the strike price of the short call with limited risk on the downside and limited profit potential on the upside.
  2. To profit from a bullish stock price move to the strike price of the short call with lower risk than a simple long call but also with limited profit potential if the stock price rises beyond the strike price of the short call.

Explanation

Example of long diagonal spread with calls

Sell 1 28-day XYZ 100 call at 3.35
Buy 1 56-day XYZ 95 call at (7.60)
Net cost = (4.25)

A long diagonal spread with calls is created by buying one “longer-term” call with a lower strike price and selling one “shorter-term” call with a higher strike price. In the example a two-month (56 days to expiration) 95 Call is purchased and a one-month (28 days to expiration) 100 Call is sold. This strategy is established for a net debit, and both the profit potential and risk are limited. The maximum profit is realized if the stock price is equal to the strike price of the short call on the expiration date of the short call, and the maximum risk is realized if the stock price falls sharply below the strike price of the long call.

Maximum profit

The maximum profit is realized if the stock price is equal to the strike price of the short call on the expiration date of the short call. With the stock price at the strike price of the short call at expiration of the short call, the profit equals the price of the long call minus the net cost of the spread including commissions. This is the point of maximum profit because the long call has its maximum difference in price with the expiring short call. It is impossible to know for sure what the maximum profit potential is, because it depends of the price of long call, and that price is subject to the level of volatility which can change.

Maximum risk

The maximum risk of a long diagonal spread with calls is equal to the net cost of the spread including commissions. If the stock price falls sharply below the strike price of the long call, then the value of the spread approaches zero; and the full amount paid for the spread is lost.

Breakeven stock price at expiration of the short call

There is one breakeven point, which is below the strike price of the short call. Conceptually, the breakeven point at expiration of the short call is the stock price at which the price of the long call equals the net cost of the spread. It is impossible to know for sure what the breakeven stock price will be, however, because it depends of the price of the long call which depends on the level of volatility.

Profit/Loss diagram and table: long diagonal spread with calls

Sell 1 28-day XYZ 100 call at 3.35
Buy 1 56-day XYZ 95 call at (7.60)
Net cost = (4.25)
Stock Price at Expiration of the 28-day Call Short 1 28-day 100 Call Profit/(Loss) at Expiration Long 1 56-day 95 Call Profit/(Loss) at Expiration of the 28-day Call* Net Profit/(Loss) at Expiration of the 28-day Call
115 (11.65) +12.60 +0.95
110 (6.65) +7.70 +1.05
105 (1.65) +3.20 +1.55
100 +3.35 (0.65) +2.70
95 +3.35 (4.00) (0.65)
90 +3.35 (6.10) (2.75)
85 +3.35 (7.10) (3.75)

*Profit or loss of the long call is based on its estimated value on the expiration date of the short call. This value was calculated using a standard Black-Scholes options pricing formula with the following assumptions: 28 days to expiration, volatility of 30%, interest rate of 1% and no dividend.

Appropriate market forecast

A long diagonal spread with calls realizes its maximum profit if the stock price equals the strike price of the short call on the expiration date of the short call. The forecast, therefore, can either be “neutral” or “modestly bullish,” depending on the relationship of the stock price to the strike price of the short call when the position is established.

If the stock price is at or near the strike price of the short call when the position is established, then the forecast must be for unchanged, or neutral, price action.

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If the stock price is below the strike price of the call when the position is established, then the forecast must be for the stock price to rise to the strike price at expiration (modestly bullish).

While one can imagine a scenario in which the stock price is above the strike price of the short call and a diagonal spread with calls would profit from bearish stock price action, it is most likely that another strategy would be a more profitable choice for a bearish forecast.

Strategy discussion

A long diagonal spread with calls is the strategy of choice when the forecast is for stock price action near the strike price of the short call, because the strategy profits from time decay of the short call. However, unlike a long calendar spread with calls, a long diagonal spread can still earn a profit if the stock rises sharply above the strike price of the short call. The tradeoff is that a long diagonal spread costs more than a long calendar spread, so the risk is greater if the stock price falls.

Long diagonal spreads with calls are frequently compared to simple vertical spreads in which both calls have the same expiration date. The differences between the two strategies are the initial investment, the risk, the profit potential and the available courses of action at expiration. Long diagonal spreads cost more to establish, because the longer-dated long call has a higher price than the same-strike, shorter-dated call in a comparable vertical spread. As a result, the risk is greater. Also, the profit potential of a long diagonal spread is less if one considers only the expiration date of the short call. The potential benefit of a long diagonal spread, however, is that, after the short call expires, the long call remains open and has unlimited profit potential. One should not forget, however, that the risk of a long diagonal spread is still 100% of the cost of the position. Therefore, even if the short call in a diagonal spread expires worthless, the remaining open long call can still incur a loss if the stock price does not rise.

Patience and trading discipline are required when trading long diagonal spreads. Patience is required because this strategy profits from time decay, and stock price action can be unsettling as it rises and falls around the strike price of the short call as expiration approaches. Trading discipline is required, because “small” changes in stock price can have a high percentage impact on the price of a diagonal spread. Traders must, therefore, be disciplined in taking partial profits if possible and also in taking “small” losses before the losses become “big.”

Impact of stock price change

“Delta” estimates how much a position will change in price as the stock price changes. Long calls have positive deltas, and short calls have negative deltas. When the position is first established, the net delta of a long diagonal spread with calls is positive. With changes in stock price and passing time, however, the net delta varies from slightly negative to approximately +0.90, depending on the relationship of the stock price to the strike prices of the calls and on the time to expiration of the short call.

If the stock price equals the strike price of the short call at expiration of the short call, the position delta approaches +0.90. In this case, the delta of the in-the-money long call approaches +0.90 (depending on volatility and on the time to expiration), and the delta of the expiring short call goes to zero.

When the stock price is above the strike price of the short call at expiration of the short call, the position delta is slightly negative, because the delta of the long call approaches +0.90 and the delta of the in-the-money expiring short call approaches −1.00.

The position delta approaches zero if the stock price falls sharply below the strike price of the long call, because the deltas of both calls approach zero.

Impact of change in volatility

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Long options, therefore, rise in price and make money when volatility rises, and short options rise in price and lose money when volatility rises. When volatility falls, the opposite happens; long options lose money and short options make money. “Vega” is a measure of how much changing volatility affects the net price of a position.

Since vegas decrease as expiration approaches, a long diagonal spread with calls generally has a net positive vega when the position is first established. Consequently, rising volatility generally helps the position and falling volatility generally hurts. The vega is highest when the stock price is equal to the strike price of the long call, and it is lowest when the stock price is equal to the strike price of the short call.

The net vega approaches zero if the stock price falls sharply below the strike price of the long call or rises sharply above the strike price of the short call. In both cases, with the options both far out of the money or both deep in the money, both vegas approach zero.

Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion. “Theta” is a measure of how much time erosion affects the net price of a position. Long option positions have negative theta, which means they lose money from time erosion, if other factors remain constant; and short options have positive theta, which means they make money from time erosion.

Long diagonal spreads with calls generally have a net negative theta when first established, because the negative theta of the long call more than offsets the positive theta of the short call. However, the theta can vary from negative to positive depending on the relationship of the stock price to the strike prices of the calls and on the time to expiration of the shorter-dated short call.

The theta is most negative when the stock price is close to the strike price of the long call, and it is the least negative or possibly positive when the stock price is close to the strike price of the short call.

Risk of early assignment

Stock options in the United States can be exercised on any business day, and holders of short stock option positions have no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.

While the long call in a long diagonal spread with calls has no risk of early assignment, the short call does have such risk. Early assignment of stock options is generally related to dividends, and short calls that are assigned early are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned.

If the short call is assigned, then 100 shares of stock are sold short and the long call remains open. If a short stock position is not wanted, it can be closed in one of two ways. First, 100 shares can be purchased in the market place. Second, the short 100-share position can be closed by exercising the long call. Remember, however, that exercising a long call will forfeit the time value of that call. Therefore, it is generally preferable to buy shares to close the short stock position and then sell the long call. This two-part action recovers the time value of the long call. One caveat is commissions. Buying shares to cover the short stock position and then selling the long call is only advantageous if the commissions are less than the time value of the long call.

Note, however, that whichever method is used, buying stock or exercising the long call, the date of the stock purchase will be one day later than the date of the short sale. This difference will result in additional fees, including interest charges and commissions. Assignment of a short call might also trigger a margin call if there is not sufficient account equity to support the short stock position.

Potential position created at expiration of the short call

The position at expiration of the short call depends on the relationship of the stock price to the strike price of the short call. If the stock price is at or below the strike price of the short call, then the short call expires worthless and long call remains open.

If the stock price is above the strike price of the short call, then the short call is assigned. The result is a two-part position consisting of a long call and short 100 shares of stock. If the stock price is above the strike price of the short call immediately prior to its expiration, and if a position of short 100 shares is not wanted, then the short call must be closed.

Other considerations

The term “diagonal” in the strategy name originated when options prices were listed in newspapers in a tabular format. Strike prices were listed vertically in rows, and expirations were listed horizontally in columns. Therefore a “diagonal spread” involved options in different rows and different columns of the table; i.e., they had different strike prices and different expiration dates.

A short diagonal spread with calls is created by selling one “longer-term” call with a lower strike price and buying one “shorter-term” call with a higher strike price.

A long diagonal spread with puts is created by buying one “longer-term” put with a higher strike price and selling one “shorter-term” put with a lower strike price.

Article copyright 2020 by Chicago Board Options Exchange, Inc (CBOE). Reprinted with permission from CBOE. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.

Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. Before trading options, please read Characteristics and Risks of Standardized Options. Supporting documentation for any claims, if applicable, will be furnished upon request.

Greeks are mathematical calculations used to determine the effect of various factors on options.

Charts, screenshots, company stock symbols and examples contained in this module are for illustrative purposes only.

DIAGONAL SPREAD

An options strategy established by simultaneously entering into a long and short position in two options of the same type (two call options or two put options) but with different strike prices and expiration dates.

Diagonal spread

In derivatives trading, the term diagonal spread is applied to an options spread position that shares features of both a calendar spread and a vertical spread. It is established by simultaneously buying and selling equal amount of option contracts of the same type (call options or put options) but with different strike prices and expiration dates.

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A call option, often simply labeled a “call”, is a contract, between the buyer and the seller of the call option, to exchange a security at a set price. The buyer of the call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial instrument from the seller of the option at a certain time for a certain price. The seller is obligated to sell the commodity or financial instrument to the buyer if the buyer so decides. The buyer pays a fee for this right. The term “call” comes from the fact that the owner has the right to “call the stock away” from the seller.

In finance, a put or put option is a stock market instrument which gives the holder the right to sell an asset, at a specified price, by a specified date to a given party. The purchase of a put option is interpreted as a negative sentiment about the future value of the underlying stock. The term “put” comes from the fact that the owner has the right to “put up for sale” the stock or index.

In financial mathematics, put–call parity defines a relationship between the price of a European call option and European put option, both with the identical strike price and expiry, namely that a portfolio of a long call option and a short put option is equivalent to a single forward contract at this strike price and expiry. This is because if the price at expiry is above the strike price, the call will be exercised, while if it is below, the put will be exercised, and thus in either case one unit of the asset will be purchased for the strike price, exactly as in a forward contract.

In finance, a straddle strategy refers to two transactions that share the same security, with positions that offset one another. One holds long risk, the other short. As a result, it involves the purchase or sale of particular option derivatives that allow the holder to profit based on how much the price of the underlying security moves, regardless of the direction of price movement.

A corporate bond is a bond issued by a corporation in order to raise financing for a variety of reasons such as to ongoing operations, M&A, or to expand business. The term is usually applied to longer-term debt instruments, with maturity of at least one year. Corporate debt instruments with maturity shorter than one year are referred to as commercial paper.

In finance, volatility arbitrage is a type of statistical arbitrage that is implemented by trading a delta neutral portfolio of an option and its underlying. The objective is to take advantage of differences between the implied volatility of the option, and a forecast of future realized volatility of the option’s underlying. In volatility arbitrage, volatility rather than price is used as the unit of relative measure, i.e. traders attempt to buy volatility when it is low and sell volatility when it is high.

In options trading, a box spread is a combination of positions that has a certain payoff, considered to be simply “delta neutral interest rate position”. For example, a bull spread constructed from calls combined with a bear spread constructed from puts has a constant payoff of the difference in exercise prices assuming that the underlying stock does not go ex-dividend before the expiration of the options. If the underlying asset has a dividend of x, then the settled value of the box will be 10+x. Under the no-arbitrage assumption, the net premium paid out to acquire this position should be equal to the present value of the payoff.

In finance, a calendar spread is a spread trade involving the simultaneous purchase of futures or options expiring on a particular date and the sale of the same instrument expiring on another date. These individual purchases, known as the legs of the spread, vary only in expiration date; they are based on the same underlying market and strike price.

The iron condor is an option trading strategy utilizing two vertical spreads – a put spread and a call spread with the same expiration and four different strikes. A long iron condor is essentially selling both sides of the underlying instrument by simultaneously shorting the same number of calls and puts, then covering each position with the purchase of further out of the money call(s) and put(s) respectively. The converse produces a short iron condor.

In options trading, a bull spread is a bullish, vertical spread options strategy that is designed to profit from a moderate rise in the price of the underlying security.

In options trading, a bear spread is a bearish, vertical spread options strategy that can be used when the options trader is moderately bearish on the underlying security.

In options trading, a vertical spread is an options strategy involving buying and selling of multiple options of the same underlying security, same expiration date, but at different strike prices. They can be created with either all calls or all puts. The term originates from the trading sheets that were used in the open outcry pits on which option prices were listed out by expiry date & strike price, thus looking down the sheet (vertical) the trader would see all options of the same maturity. Vertical spreads can sometimes approximate binary options, and can be produced using vanilla options.

In finance an iron butterfly, also known as the ironfly, is the name of an advanced, neutral-outlook, options trading strategy that involves buying and holding four different options at three different strike prices. It is a limited-risk, limited-profit trading strategy that is structured for a larger probability of earning smaller limited profit when the underlying stock is perceived to have a low volatility.

Option strategies are the simultaneous, and often mixed, buying or selling of one or more options that differ in one or more of the options’ variables. Call options, simply known as calls, give the buyer a right to buy a particular stock at that option’s strike price. Conversely, put options, simply known as puts, give the buyer the right to sell a particular stock at the option’s strike price. This is often done to gain exposure to a specific type of opportunity or risk while eliminating other risks as part of a trading strategy. A very straightforward strategy might simply be the buying or selling of a single option; however, option strategies often refer to a combination of simultaneous buying and or selling of options.

Options spreads are the basic building blocks of many options trading strategies. A spread position is entered by buying and selling equal number of options of the same class on the same underlying security but with different strike prices or expiration dates. The three main classes of spreads are the horizontal spread, the vertical spread and the diagonal spread. They are grouped by the relationships between the strike price and expiration dates of the options involved –

A Ratio spread is a complex, multileg options position that is a variation of a vertical spread. Like a vertical, the ratio spread involves buying and selling options on the same underlying security with different strike prices and the same expiration date. Unlike a vertical spread, a number of option contracts sold is not equal to a number of contracts bought. An unequal number of options contracts gives this spread certain unique properties compared to a regular vertical spread. A typical ratio spread would be where twice as many option contracts are sold, thus forming a 1:2 ratio.

The backspread is the converse strategy to the ratio spread and is also known as reverse ratio spread. Using calls, a bullish strategy known as the call backspread can be constructed and with puts, a strategy known as the put backspread can be constructed.

In finance, an option is a contract which gives the buyer the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price prior to or on a specified date, depending on the form of the option. The strike price may be set by reference to the spot price of the underlying security or commodity on the day an option is taken out, or it may be fixed at a discount or at a premium. The seller has the corresponding obligation to fulfill the transaction – to sell or buy – if the buyer (owner) “exercises” the option. An option that conveys to the owner the right to buy at a specific price is referred to as a call; an option that conveys the right of the owner to sell at a specific price is referred to as a put. Both are commonly traded, but the call option is more frequently discussed.

In finance, a credit spread, or net credit spread is an options strategy that involves a purchase of one option and a sale of another option in the same class and expiration but different strike prices. It is designed to make a profit when the spreads between the two options narrows.

In finance, a strangle is a trading strategy involving the purchase or sale of particular option derivatives that allows the holder to profit based on how much the price of the underlying security moves, with relatively minimal exposure to the direction of price movement. A purchase of particular options is known as a long strangle, while a sale of the same options is known as a short strangle. As an options position strangle is a variation of a more generic straddle position. Strangle’s key difference from a straddle is in giving investor choice of balancing cost of opening a strangle versus a probability of profit. For example, given the same underlying security, strangle positions can be constructed with low cost and low probability of profit. Low cost is relative and comparable to a cost of straddle on the same underlying. Strangles can be used with equity options, index options or options on futures.

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