Diagonal Spread
A diagonal spread was an options strategy involving the simultaneous purchase and sale of options on the same underlying but at different strikes and different expiry dates, combining elements of a calendar spread and a vertical spread to create a position that profited from time decay, directional movement, or both.
The diagonal spread owed its name to the fact that, when plotted on a grid of strikes versus expiries, the two legs occupied positions that were diagonal to each other — different rows (strikes) and different columns (expiries). The most straightforward version involved buying a longer-dated option at a lower strike and selling a shorter-dated option at a higher strike (for a bullish diagonal) or buying a longer-dated option at a higher put strike and selling a nearer-dated put at a lower strike (for a bearish diagonal).
In India's NSE options market, the monthly and weekly expiry structure supported diagonal spreads effectively. A trader might buy a next-month Nifty call at an ATM or slightly OTM strike and simultaneously sell the current-week OTM call. The short near-dated option decayed rapidly in the days approaching its weekly expiry, while the longer-dated option retained much of its time value. If the index rose modestly but stayed below the short strike at the near-dated expiry, the short leg expired worthless, the premium was retained, and the long option continued to provide upside exposure for the remainder of its life.
The primary appeal of the diagonal spread was capital efficiency. Buying a longer-dated option outright was expensive; the short near-dated leg financed a portion of that cost through recurring premium collection as the short leg was rolled forward expiry by expiry. This rolling premium collection lowered the effective cost basis of the long option over time — a strategy that paralleled the covered call concept but applied to long options rather than long stock.
Implied volatility differentials between expiries — the IV term structure — had a significant influence on diagonal spread profitability. If near-dated IV was elevated relative to far-dated IV (a condition known as inverted term structure, common in India before major events), the premium received from the short near-dated option was relatively rich, improving the economics of the position. Conversely, if the term structure was normal (far-dated IV higher than near-dated), the short leg contributed less relative premium.
Management complexity was higher than a simple vertical spread because two separate expiry cycles needed to be tracked. When the near-dated short option approached expiry, the trader had to decide whether to close it and roll to the next near-dated strike, close the entire structure, or convert it into a different configuration. Gamma risk near the near-dated expiry was the most acute concern, particularly if the underlying was close to the short strike.