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How to set up diagonal spreads

Venkatesh Bangaruswamy | Updated on November 20, 2021

Gets the name from how options used to be displayed for traders

Picture this. You have a bearish view on the underlying. You are uncertain if the underlying will reach your price target before the near-term contract expires. What should you do? In this article, we discuss why a diagonal spread could be optimal in such cases.

Time and volatility

Suppose you set up a diagonal put spread on the Nifty Index by going long the 17900 next-week put and short the 17700 near-week put when the index is at 18000. Based on market convention, this would be a long spread as it is a net debit spread (set up for 93 points). That is, premium paid on the long put is greater than the premium received on the short put.

Note that this spread benefits from delta and vega. That is, the spread will benefit if the underlying declines, as the delta of the long put is greater than the delta of the short put. Also, the position will gain if volatility of the Nifty index increases. This is because the long put has a higher vega than the short out-of-the-money (OTM) put. Also note that long term options have higher vega than short term options for the same strike.

Suppose the Nifty index declines by 200 points to 17800 three days after you setup the diagonal spread. Assuming no change in implied volatility, the spread could increase to 136 points for a gain of 43 points (136 less 93). You may have to close the spread when the index approaches the next tradable strike even if you expect the underlying to decline further; for liquidity of the 17900 strike could decline as the strike becomes in-the-money (ITM). This is because traders typically prefer ATM and OTM options. And you would have to sell the ITM option to capture gains because NSE offers European options, which can be exercised only at expiry.

What if the Nifty index declines by 200 points just three days before expiry of the near-month contract? The spread could be worth 154 points and the gain 60 points. Your gains are greater because time decay of the near-week short strike is greater than the time decay of the next-week long strike. The position will gain even more if the implied volatility increases during this period, as the spread is vega-positive.

Finally, what if the Nifty Index declines by 200 points six days before the expiry of the next-week contract? This means the near-week contract would have expired worthless. The next-week contract could be worth 179 points and the position could gain 86 points. Thus, the gains are greater if your price target is reached after the near-week contract expires.

Optional reading

Suppose the Nifty index moves up to 18100. The diagonal spread would suffer losses; the loss on the long put because of decline in delta (along with time decay) will be more than the gain from short put because of time decay. This also explains why the spread loses more if the index moves to 18100 three days before expiry of the near-week contract compared to six days. The maximum loss is the net debit.

Diagonal spread gets its name from how options used to be displayed for traders. Each column had contract expiry dates and each row the strikes. So, a bull call spread would be two different rows in the same column and, hence, called vertical spread. The same strike call spread between near-month and the next-month would be between two columns of the same row. Hence, such calendar spreads were called as horizonal spreads.

In this context, a diagonal spread is one where you go long on a strike of a certain maturity and short a different strike of another maturity. Thus, strikes are matched between a row in one column and a different row in another column. Hence, the term diagonal spread.

The author offers training programmes for individuals to manage their personal investments

(This is a free article from the BusinessLine premium Portfolio segment. For more such content, please subscribe to The Hindu BusinessLine online.)

Published on November 20, 2021

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