In this article we go into diagonal spreads, how they differ from vertical spreads, and when to use them.
Capital Efficiency
Intro to Spreads
They are used to generate income through the sale of short options while using a long option as collateral instead of the underlying stock. They are capital efficient because they require a fraction of the income required for the equivalent exposure to the underlying stock. Listed below are the most common spread types:
- Vertical Spread – different strikes with same expiration
- Calendar Spreads – same strikes with different expirations
- Diagonal Spreads – different strikes and different expirations
Vertical Spreads
Vertical spreads use two different strike prices for options that have the same expiration. Verticals are used when you have a strong directional prediction for a stock as it approaches the expiration date. With verticals, the long leg of the spread covers the short leg. The strategy with these if opened as a credit spread is to predict where you can open out of the money short and long legs without them being assigned at expiration. The long leg will be further out of the money than the short leg in this case with the max profit being the premium collected upfront and the max loss being the difference between the short and long strikes minus the premium collected upfront.
Calendar Spreads
Calendar spreads use the same strike price for options that have two different expirations. Calendars are used when you have a strong neutral prediction for a stock as it approaches the short expiration date.
Diagonal Spreads
Why Diagonal Spreads are Used
Diagonal spreads are similar to vertical spreads and calendar spreads and are essentially a combination of the two. Diagonal spreads use options with two different strike prices as well as two different expiration dates. Diagonals are used when you have a strong directional prediction for a stock as it approaches the long expiration date.
