What Is The Diagonal Spread Strategy?
Options contracts are one of the most sophisticated financial instruments that traders and investors use to profit from any given asset's price movements.
Like futures contracts, option contracts minimize the buyer’s risk by assigning a predetermined price to an asset. Unlike futures contracts, however, there is no obligation for options buyers to purchase the asset before trading.
Options have been in existence for centuries, with crypto options being the new kid on the block. To meet increased consumer interest and demand, more brokers and exchanges have begun creating their own crypto options. Today, users can easily access and trade such options in a matter of seconds. Strategies used for trading conventional options can also be applied to crypto options.
In this article, we’ll discuss an important options trading strategy — the diagonal spread — and learn how it’s relevant in the context of cryptocurrency.
Diagonal Spread Strategy Setup
There are two main diagonal spread strategies: Diagonal spread put, and diagonal spread call.
Diagonal Put Spread Strategy — Setup
Source: The Options Playbook
The diagonal spread put involves selling an out-of-the-money (OTM) put option with a near-term expiration date (front-month)/strike price B.
Then, buy an OTM put option with an approximate expiration of one month (back-month)/strike price A.
You must sell another put option at the near-term expiration with strike price B and the same expiration as the back-month put option.
Typically, the price of the asset class will be above strike price B.
Diagonal Call Spread Strategy — Setup
Source: The Options Playbook
In the diagonal spread call strategy, sell an OTM call option with an approximately one-month expiration (front-month)/strike price A
Then, buy an OTM call option with an approximate two-month expiration (back-month)/strike price B
At the front-month call's expiration, you must sell another call option with strike price A and the same expiration date as the back-month call option.
Typically, the price of the asset class will be below strike price A
Diagonal Spread Strategy
The diagonal spread serves as an alternative to typical calendar spread strategies, and can be lucrative if applied correctly. A "low intrinsic value" environment strategy, the level of flexibility and adaptability it offers are second to none.
Who Can Use the Diagonal Spread Strategy?
The diagonal spread strategy involves trading multiple options with different expiration dates and strike prices. Therefore, extensive technical knowledge and practice is required to master the strategy. If you’re well-versed in the field of options, this is — without a doubt — an excellent strategy to implement.
When to Use a Diagonal Spread Strategy
The diagonal spread put strategy must be used when you’re either bullish or neutral on the stock or any given asset class. Use this strategy when you expect:
- Neutral price action of the asset class in the front month
- Neutral-to-bullish price action in the back month
Conversely, you can use the diagonal spread call strategy when you’re bearish or neutral on the asset class you prefer to trade. Use this strategy when you expect:
- Neutral price action of the asset class in the front month
- Neutral-to-bearish price action in the back month
Determining the breakeven point when using a diagonal spread strategy can be tricky, as several variables are involved. As discussed, there are two strike prices and expiration dates in this strategy. Therefore, a complex pricing model is required to determine the value of the back-month's call at the expiration of the front-month call.
Diagonal Spread Strategy Sweet Spot
Once you’ve determined the sweet spot for any strategy, the best way to remember it is by putting it into practice. Below are the sweet spots for both the diagonal spread put and diagonal spread call strategies.
For Diagonal Spread Call Strategy
- The underlying asset's price is at or around strike price A until the front-month option's expiration date.
- When the back-month option expires, the asset’s price is below strike price A.
For Diagonal Spread Put Strategy
- The underlying asset's price is at or around strike price B until the front-month option's expiration date.
- When the back-month option expires, the asset’s price is below strike price B.
Diagonal Spread Strategy Example
In short, here’s how the diagonal spread strategy works: First, you need to go into the back month and buy an option that’s in-the-money (ITM). Then, step into the front month and sell the option OTM.
Here’s a hypothetical scenario: Let’s assume you’re bullish on BTC, and one BTC is currently selling for $20,000, with the front-month July, and the back-month August. Therefore, go into August and buy the $18,000 strike call (2,000 strikes ITM). Then, go back into July and sell the $22,000 strike call (2,000 strikes OTM). This will give you a $4,000 diagonal spread.
Based on the example above, let’s take a look at the setup for a bearish market. Go into August and buy a $19,000 put (1,000 strikes ITM). Then, backtrack into July and sell the $21,000 put (1,000 strikes OTM). The result? A $2,000 put diagonal spread.
Diagonal Spread Strategy Tips
1. Be Careful Not to Overpay
One key tip is not to overpay for your diagonal spread. Ideally, do not pay more than 75% of the spread’s width.
Remember that the spread's width, minus the debit you’ve paid, is your profit potential. Considering our earlier example (the $2,000 diagonal spread in BTC), the spread would be $1,500. Therefore, the maximum profit potential would be the remaining 25%, or $500. If you pay too much for your diagonal spread, you won't make any money — even when the asset's price goes in your direction.
2. Use the Mini Diagonal
What if you’re at breakeven, and there are 21 days until the options expire? Roll that short option forward into a weekly cycle — and go for the mini diagonal. Unless your directional bias has changed, this strategy will allow you to take full advantage of your flexibility.
3. Make Adjustments in Bearish Markets
Unfortunately, there will be times when your directional bias fails. For instance, an asset’s price may decrease after you place a diagonal call. Conversely, an asset’s price may increase after you place a diagonal put spread.
Don't panic if this happens — that's the beauty of the diagonal spread. Remember that, per your setup, there’s a distance between your long and short options. So, what do you do?
In this scenario, there are three possible adjustments you can make:
Roll the short strike forward for credit: You could roll on the short option forward, like a weekly cycle, and create a sort of mini diagonal spread. You’ll be able to do this for credit. This is probably the most standard adjustment to a diagonal spread.
Roll the short strike forward: You could roll forward into a mini diagonal spread, and simultaneously roll your short strike. This shrinks the width of your diagonal spread. By choosing to do this, you’ll aggressively collect more credit.
(A word of caution: Be careful not to shrink the width so far that the net debit you’ve paid exceeds the diagonal spread's width. If you do that, you’ll be locked in a loss. In this case, debit cannot exceed the spread's width.)
Roll the short strike to the same month as the long strike: Roll the short option into the back month with the long option. This creates a vertical spread in the back-month cycle.
If you get the move you’ve anticipated, when should you make these adjustments? It’s up to you, but the recommendation is usually no sooner than when you have 21 days to go, or sometimes even later in the cycle. This is a defined risk strategy, where your maximum loss is approximately the cost you’ve paid for the diagonal spread.
Maximum Take-Profit Potential
With the diagonal spread options trading strategy, it’s difficult to calculate the maximum profit potential at the beginning. This is because profits made are determined by the premium received after later selling the second put option.
Using this strategy, the profits you make are limited to the net credit received after selling both of the put options with strike price B.
Here’s the formula to determine your true profit:
True Profit = Total Profit − Premium Paid for the Put Option − Strike Price A
For the diagonal call options strategy, the profit can be determined by subtracting the premium paid for the call option with strike price B from the net credit received after selling both of the call options with strike price A.
Maximum Incurred Loss Potential
Similar to maximum profit potential, maximum loss is also difficult to determine when trading this strategy (for the same reasons mentioned above).
In the case of a net credit, your maximum risk can be determined by subtracting strike price B from strike price A, minus the total net credit you’ve received:
Net Credit Maximum Risk = Strike Price A − Strike Price B − Total Net Credit Received
In the case of net debit, your maximum risk can be determined by subtracting strike price B from strike price A, and adding the net debit you’ve paid:
Net Debit Maximum Risk = Strike Price A − Strike Price B + Net Debit Paid
The margin requirement is the difference between both of the strike prices if you close the position at the front-month option's expiration. In the case of a net credit, the proceeds will be applied to the initial margin requirement. This applies to both diagonal call and diagonal put spreads.
Theta Decay Impact
We know that a shorter-term put will lose value faster than the longer-term put for the diagonal spread put strategy. Therefore, before the front-month expiration, time decay (Theta) is your best friend.
Here’s an example: Let's say you close a front-month put option with strike price B, and sell another put option with the same strike price. However, the other put option has the same expiration date as the back-month put option, with strike price A. In this case, the time decay is somewhat neutral, due to the erosion in both the option values you’ve bought and your sold options.
The same principle applies to the diagonal spread call strategy, but the strike price interchange (as well as call options) is involved.
Implied Volatility Effect
While trading the diagonal spread call, although you may be anticipating neutral movement on the asset class’s price (if it’s ≤ strike price A) close to the expiration of the front month, increased implied volatility could work in your favor. In the case of implied volatility, you could sell another call option at strike price A and receive a higher premium. The same applies to the diagonal spread put as well.
- One of the primary benefits of trading the diagonal spread strategy is its flexibility. You can make numerous position adjustments during the trading process, which isn’t possible with many other option strategies.
- The positions you enter using this strategy are cheaper than the typical covered call, and come with lower risk levels.
- The percentage return is also greater than with the traditional covered call.
- Traders of this strategy can profit from time decay.
Fees are expensive due to multiple trades.
This strategy can be confusing, and novices may struggle to understand how it works. Also, as mentioned, there ‘s a risk of overpaying your diagonal spread, which could lead to losses.
Buying Options on Bybit
As seen in the snapshot below, all of the options available on the exchange are listed. Locate the specific option you want, and click on Trade to get started.
You can then see all of the available call and put options, along with their corresponding strike prices.
Click on the call/put option of your choice, enter the quantity of the crypto you want to trade, and then place your order. Likewise, you can follow the procedure for the diagonal spread strategy and place the call and put options as discussed above. Here’s the full guide to trading BTC options on Bybit.
A hybrid strategy, the diagonal spread is a part-vertical/part-calendar spread that has both directional and time components. While applying this strategy, if the underlying asset's price moves in your direction, you can get paid quickly, and also benefit in the long term. Arguably, this makes the diagonal spread one of the most attractive option strategies available. However, beginners may need to look elsewhere, as the strategy takes significant knowledge to implement.