The Diagonal Spread Strategy is an advanced options trading technique that combines features of calendar spreads and vertical spreads. It involves buying and selling options of the same type (either calls or puts) on the same underlying asset, but with different strike prices and different expiration dates. This creates a unique risk-reward profile that allows traders to benefit from time decay, directional moves, and volatility changes.

In the FX market, diagonal spreads can be deployed using currency options to express nuanced views on both direction and timing, making them popular among institutional traders, especially in event-driven environments.

What Is a Diagonal Spread?

A diagonal spread involves two options:

• Long leg: Farther-dated option (e.g. 1-month expiry)
• Short leg: Nearer-dated option (e.g. 1-week expiry)
• Strike prices: Different for each leg (unlike calendar spreads)

There are two main types:

• Diagonal Call Spread: Bullish to moderately bullish outlook
• Diagonal Put Spread: Bearish to moderately bearish outlook

How the Strategy Works

1. Set Directional Bias
   Determine whether you’re expecting a rise or fall in the underlying FX pair.
2. Select Expiry Dates
   Choose a near-term expiry for the short leg and a longer-term expiry for the long leg.
3. Pick Strike Prices
   Place the short leg closer to the current price and the long leg further away to balance time decay and directional exposure.
4. Profit From Theta and Movement
   The short option decays faster, and if the underlying moves favourably, the long leg gains value.
5. Roll or Close
   Once the short leg expires, you can either close the trade or roll it forward to another expiry for continued income.

Example: Diagonal Call Spread in EUR/USD

• View: EUR/USD will rise moderately over the next month
• Long Leg: Buy 1-month call at 1.1000
• Short Leg: Sell 1-week call at 1.1050
• Outcome:
  • If EUR/USD rises slowly, the short call expires worthless, and the long call gains
  • If it spikes above 1.1050 quickly, gains are capped unless rolled
  • If EUR/USD stays flat, you profit from the short leg’s time decay

Ideal Conditions for Diagonal Spreads

• Neutral to Directional Outlook: Moderate moves in price favour the setup
• High Implied Volatility in Near-Term: Helps sell rich short-dated options
• Lower Implied Volatility in Long-Term: Keeps long leg affordable
• Known Events: Central bank decisions, NFP, or elections where you expect movement with timing uncertainty

Key Strategy Benefits

• Time Decay Advantage: Short leg loses value faster, creating net theta income
• Volatility Skew: Profit from differences in implied vol across expiries
• Defined Risk: Loss is limited to net debit paid
• Flexibility: Can be adjusted or rolled for ongoing yield generation

Risks and Limitations

• Complex P&L Profile: Requires monitoring both legs
• Gap Risk: Large, fast moves can trigger losses on the short leg
• Volatility Crush: Drop in IV post-event can hurt the long leg’s value
• Margin Requirements: May be higher with wide strikes and multi-leg exposure

Risk Management Tips

• Set Max Loss at Entry: Keep position sizing within defined risk limits
• Use for Range Breakouts or Moderated Trends: Not ideal for extreme moves
• Monitor Time Value: Exit or adjust when short leg is close to expiry
• Avoid Holding Through High-Risk Events: Unless fully hedged

Use Case: GBP/USD Diagonal Put Spread Before BoE Meeting

• Trader expects GBP to weaken gradually over a few weeks
• Buys 1-month GBP/USD put at 1.2650
• Sells 1-week put at 1.2600
• Outcome: If GBP/USD declines slowly, the short put expires and the long put retains value
• Trader can roll the short put weekly to generate yield while holding bearish exposure

Conclusion

The Diagonal Spread Strategy is a powerful tool for traders who want to benefit from both directional price movement and differential time decay. With proper structuring, it allows for limited-risk exposure to macroeconomic events, earnings reports, or anticipated trends, particularly in the FX options market.

To learn how to build, adjust, and manage diagonal spreads effectively in real-world trading, enrol in our Trading Courses designed for advanced options and macro-driven forex traders.