The diagonal calendar spread uses a different strike price in the near-term option than in a longer-term option. This can be a credit spread or a debit spread.
For a diagonal credit spread:
- the strike price of the long option is out-of-the-money.
- the strike price of the short option is at-the-oney.
The credit diagonal spread frequently works best then the 2 strike prices are no more than $2.50 apart, because it keeps the maxium risk on the trade at a reasonable level.
Replicating the diagonal calendar spread
The credit diagonal spread can also be viewed as:
- a regular calendar spread
- a front-month credit spread (vertical spread)
A vertical spread provides a credit that finances the cost of the calendar spread.
An example:
- Buy 1 Oct 126 call
- Sell 1 Sep 126 call
- Buy 1 Sep 126 call
- Sell 1 Sep 124 call
When the credit diagonal spread is created with calls, the attitude is that the price of the underlying will move either sidewaysor downward.
When the credit diagonal spread is created with puts, the profit zone caters to a sideways or upward movement.
Debit diagonal spreads
This basic idea for a debig diagonal spread is:
- The strike price of the short option is out-of-the-money.
- The strike price of the long option is at-the-money.
This reduce the cost basis for the long option while allowing more some movement in the price of the underlying in a direction favourable to the long option.
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