To The Moon

Multi-leg Option Strategy: Diagonal Spread (Diagonal Puts)

Diagonal Spread

A diagonal spread is a multi-leg option strategy that involves two option contract of the same type, either 2 CALL options or 2 PUT options. For a two CALL option strategy, it is called Diagonal Calls. For a two PUT options strategy, it is called Diagonal Puts.

Why is it called a spread?

It is called a spread because it involves two options contract that is spread across time and/or price. One option contract must be a BUY contract and the other option contract must be a SELL contract. There are two other spread strategies using two options contracts (Calendar spread and Vertical Spread). I will briefly touch on those in this post.

Why is it called a diagonal spread?

As described earlier, the spread can be across time and/or price. A spread across time only is called a horizontal spread or calendar spread. This means that the two options contract has the same strike price, but expires at different time. A spread across strike price only is called a vertical spread. This means that the two options contract has the same expiry date, but a different strike price. If the two options contract have different strike price and different expiry date, it is called a diagonal spread.

How to use a diagonal spread?

There are a total of 4 different combination for each type of spread (diagonal spread, calendar spread, or vertical spread). Which combination to choose will depend on whether the trader is bullish or bearish about a stock and the duration the trader plans to execute the trade.

For this post, I will describe a scenario which is relatively common if you have been selling simple single stage options (PUT or CALL options) for a while. This is called rolling options. You can read more about what is rolling options in my Demystifying Options Part 8. Using this case study, I will describe how you can use the spread strategy to recover from a simple single stage options (SELL PUT or SELL CALL) that is going in the wrong direction.

Scenario for SELL PUT

Let's say I sold a PUT option on SE with a strike price of $150 on the 10 Jan 2022. The stock price was $164 and the contract expiry date was 4 Feb 2022. The premium collected was $2.88 per share. The total amount of premium collected was $288. The option contract is OTM (Out of the money).

We all know what happen next. The share price of SE plunge to $140 on the 27 Jan 2022. The SELL PUT option is ITM (In the money).

Since it was looking likely that the share price will continue to fall and I do not want to let my option be exercised on expiry, I can roll the option.

Rolling the option means pushing the expiry of the option further into the future. I can either do a calendar spread or a diagonal spread. A calendar spread means keeping the strike price at $150 and selecting the option expiry into the future, say Mar or Apr 2022 option expiry. Another method is to do a diagonal spread. I will reduce the strike price to $140 and select the option expiry into the future, say Apr or May 2022.

The main idea of rolling options is to continue to earn option premium while waiting for the share price to move in the direction we want.

Note that if the share prices move drastically, such as in the current situation where daily price movement drops more than 5%, the option contract will likely be deep ITM. This means that it might be almost impossible to find a strike price that is OTM and still earn option premium.

In such situation, there are 2 ways to solve this issue:

1)     Just close out the position and take the loss if you have no intention of owning the shares.

2)     Roll to a strike price lower than the current strike price, but still ITM. This roll must still achieve positive option premium. (e.g. Rolling from $150 to $140 strike price and extend the expiry by 9 months). The lower strike price is still ITM, but it helps to reduce the exercise price, yet earn premium while waiting.

The exact opposite of what I described for SELL PUT will apply to SELL CALL options.

Things to pay attention to when executing a diagonal spread

1.     Spread involves two contracts. One BUY and one SELL contract. Both contracts should become valid within a short period of time. If only one of the BUY or SELL contract is executed, the end result would be a loss.

2.     There is no guarantee that the buyer will not exercise the SELL option prematurely. If it is exercised, the strategy will end, typically with the stock being bought at the strike price for diagonal puts, and stocks will be sold at the strike price for diagonal calls. This may or may not be what you want.

3.     For low volatility options or deep ITM options, it is possible that there is no diagonal spread combination that can produce a positive option premium. This means that no matter what combination you choose, you will have to pay to change the strike price instead of getting cash back. In this case, one can consider calendar spread.

In Demystifying Options part 14, I will be discussing Calendar spread.

Always remember.. If you do not understand what is happening, do not blindly follow and execute the trade!

@TigerStars