What is a Diagonal Spread?
A Diagonal Spread is a strategy where you combine different strike prices and expiration dates to profit from moderate stock price movement and time decay. It is a mix of a vertical and calendar spread.
- Buy a long-term option (e.g., $110 strike price, expiring in 6 months).
- Sell a short-term option (e.g., $100 strike price, expiring in 1 month).
How Payoff Works:
This strategy is best used when you expect **moderate stock movement** toward the strike price of the long-term option and the short-term option to lose value quickly due to **time decay**.
If the stock price rises moderately toward the long-term strike price, the short-term option will decay quickly (time decay), and the long-term option will gain value, generating profit.
Why Use This Strategy?
- Time Decay: You benefit from the rapid decay of the short-term option’s value.
- Moderate Price Movement: The strategy is best suited for slow to moderate price movement.
- Reduced Upfront Cost: It provides a cheaper alternative to buying a long-term call outright.
Example Payoff Scenarios:
- Initial Setup: You pay a net debit of $300 to enter the position. You sell a short-term option at $100 and buy a long-term option at $110.
- Stock Price = $100 (at short-term expiration):
- The short-term option (strike $100) expires worthless because the stock price is at the strike price.
- The long-term option (strike $110) still holds time value but no intrinsic value since the stock price is below the strike price.
- Net Payoff: You lose only the net debit, $300.
- Stock Price = $105 (at short-term expiration):
- The short-term option (strike $100) is in the money, and you lose $500 from this option (since the stock is $5 above $100).
- The long-term option (strike $110) has time value but no intrinsic value yet.
- Net Payoff: Loss of $500 from the short-term option, plus the net debit. Total loss = $800.
- Stock Price = $115 (at short-term expiration):
- The short-term option (strike $100) is deeply in the money, and you lose $1,500 from this option.
- The long-term option is in the money, giving you $500 of intrinsic value (since the stock is $5 above $110).
- Net Payoff: Loss from the short-term option exceeds the gain from the long-term option. Total loss = $1,300.