Real-World Trading: The Diagonal Spread

One of the biggest advantages of trading options is the ability to create numerous strategies that can fit your risk profile and market outlook. However, this flexibility comes at a cost, which is time. Because so many strategies can be implemented using options and stocks, we need to spend time understanding them.

I particularly like options because they allow us to hedge risk while still achieving solid profits. If we choose to trade only stocks, we're limited to bullish or bearish outlooks. But stocks often trade sideways, meandering back and forth in a range. We're looking for this type of movement -- or lack thereof -- in a stock when we're interested in entering a diagonal spread.

Before going into the details, I'll first define a spread in general. We often hear the term vertical spread or horizontal spread, so let me explain why these spreads are so named. When options were first introduced, a trader would find these on an options chain. The strikes would be listed vertically, while the months would be listed horizontally. When we trade a vertical spread, we are using the same months, but different strikes. Horizontal spreads use the same strike, but different months.

Thus, a bull call or bear put spread are considered vertical spreads, while a calendar spread is also called a horizontal spread. When we use different strikes and different months, we are moving diagonally across the page, thus the name diagonal spread.

There are various ways to use a diagonal spread, but for our purposes, we'll discuss the normal use of a diagonal spread. This is when we sell a front-month, lower-strike call option and buy a longer-term, higher-strike call option or when we sell a front-month higher-strike put option and buy the longer-term, lower-strike put. Here's a basic risk graph of a diagonal call spread.

Diagonal and calendar spreads use two different expiration months. Thus, the risk graph is a picture of the trade at the time the front-month option expires.