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All Learners Need To Know About Diagonal Spread Before learning Utilizing Diagonals to Increase Flexibility
The Definition of Diagonal Spread
A Diagonal Spread is built up by purchasing a call/put far out in time, and selling a near term put/call on a further OTM strike to reduce cost basis. The trade has just two legs, but it has the influence of a long vertical spread in terms of directionality, and a calendar spread in terms of its positive vega.
A Long Put Diagonal Spread is built up by purchasing a put far out in time and selling a near term put on a further OTM strike to reduce cost basis. The trade has only two legs, but it gives the effect of a long vertical spread when talking about directionality, and a calendar spread in terms of its positive vega. This results in a bearish position that can be a result of an increase in implied volatility. A Long Put Diagonal Spread is commonly used to replicate a covered put position.
To lower cost basis, a Long Call Diagonal Spread is created by buying a call far out in time and selling a near-term call on a different OTM strike. Although this trade only has two legs, it has the directionality of a long vertical spread and the positive vega of a calendar spread. As a result, a bullish position is formed, which can profit from a rise in implied volatility. To simulate a covered call position, a Long Call Diagonal Spread is typically employed.
How to setup trading toolbox
The trade will be entered for a debit. It’s vital that the debit paid is no more than 75% of the width of the strikes.
With Long Put Diagonal Spread, firstly you will buy an in-the-money (ITM) put option in a longer-term expiration cycle (Expiration 2). Secondly, your next step will be to sell an out-of-the-money (OTM) put option in a near-term expiration cycle (Expiration 1).
XYZ Stock at $100
- Purchase (Expiration 2) 110 put for $15
- Sell (Expiration 1) 90 put for $5.00
- Net debit = $10.00 on a 20-point-wide long put diagonal spread
With Long Call Diagonal Spread, firstly you will buy an in-the-money (ITM) call option in a longer-term expiration cycle (Expiration 2). Then, your move will be sell an out-of-the-money (OTM) call option in a near-term expiration cycle (Expiration 1)
XYZ Stock at $100
- Purchase (Expiration 2) 90 call for $15
- Sell (Expiration 1) 110 call for $5
- Net debit = $10.00 on a 20-point-wide long call diagonal spread
How to calculate max profit/breakeven (s)
Due to the different expiry cycles employed, the precise maximum profit potential cannot be computed. The profit potential, on the other hand, maybe evaluated using the calculations below.
The break-even cannot be calculated due to the differing expiration cycles used in the trade. As a rough estimate, the break-even area can be approximated with the following formulas.
The way a diagonal spread is put up is crucial. If we have a poor setup, we may set ourselves up to lose money if the transaction goes too quickly in our way. We verify the extrinsic value of our longer-dated ITM option to ensure we have a suitable arrangement. We make sure that the near-term option we sell is equal to or more than that amount once we’ve calculated it. The more ITM we have in our long option, the easier it is to get this configuration. We also make sure that the total debit paid does not exceed 75% of the strike width.
We never route diagonal spreads in volatility instruments. Each expiration acts as its own underlying, so our max loss is not defined.