Diagonals Option Strategy

The purchase of one or more options and sale of one or more options with a different strike and expiration is called a diagonal spread. Buying 2 February 100 calls and selling 1 January 90 call is an example of a 2 by 1 diagonal call spread. The profit and loss potential of this type of spread is somewhat similar to the backspread, but not exactly the same.

It is difficult to analyze these spreads so it is not easy to graph the profit and loss potential of a diagonal. For example, buying the 2 by 1 call diagonal should be profitable if the market goes up in a strong move. However, the January future might rally much more than the February future due to an inverted market, which would cause the January 90 call to gain more than the February 100 call. In this case an investor could lose money even if the market moves much higher. If the market creeps up slowly the January 90 call may increase in value, but the February 100 calls may stay the same price or even drop in value. Even if no inversion occurs, a trader could lose money in a diagonal spread if the market slowly rises because the January 90 call might move more than the February 100 call.

Diagonal spreads can become rather complex to analyze, especially if the underlying futures market changes from a normal market to an inverted market. Any diagonal must be understood with a thorough knowledge of the volatility of the market and the spread differentials between the two different expirations.