Diagonal Spread

Definition

The term diagonal spread refers to a strategy that involves the simultaneous purchase and writing of two options of the same type with different strike prices and expiration dates.  Diagonal spreads also involve the same underlying asset.

Explanation

When executing a diagonal spread, the investor assumes both a long and short position in options of the same type (calls or puts).  Each option has the same underlying security, but different strike prices and expiration dates.  For example, the writing of a May $40 call and the purchase of a July $35 call would be a diagonal spread.

Generally, diagonal spreads take two forms:

  • Diagonal Call Spreads:  if the investor is bullish on the underlying asset, they can use a diagonal bull spread to profit from the asset's increase in value.  A diagonal call spread involves the writing of a higher strike price call option with a near-term expiration date and the simultaneous purchase of a lower strike price call option with a longer-term expiration date.
  • Diagonal Put Spread:  if the investor is bearish on the underlying asset, they can use a diagonal bull spread to profit from the asset's decrease in value.  A diagonal put spread involves the writing of a lower strike price put option with a near-term expiration date and the simultaneous purchase of a higher strike price put option with a longer-term expiration date

Related Terms

equivalent strategy, equity option, early exercise, derivative