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A diagonal spread is a stock option strategy whereby an investor opts to buy and sell two different option holdings within the same class of stocks at different strike prices and with different expiration dates. A diagonal spread, therefore, is predicated upon buying and selling two calls, or purchase rights, as well as buying and selling two puts, or selling rights, of the same options simultaneously.
The term diagonal spread is unique to stock options. A stock option is permission, granted by a signed contract, to the legal holder of a share or shares of stock by the company issuing the stock(s) to purchase the company’s stock at a specific price stated on the option contract and within a specific time frame. Stock options are purchased -- in some cases earned -- rights to take advantage of a stock’s future dividends if the price of the stock rises or risk that advantage if the price falls at the end of the expiration date of the contract.
A diagonal spread is designed to defray risk for the holder of options through the simultaneous selling and buying of different option rights for a higher or lower price, also known as the strike price, and the results of which will be realized within a set period of time which varies considerably, but is not more than a year. Put as simply as possible, a diagonal spread is akin to simultaneously betting for and against both teams in the same game.
When initiating a diagonal spread, an investor will buy and sell calls and puts on two different stock options at differing strike prices. The strike price is the price of a share of stock at the time the investor signs the option contract. Should the strike price be higher on the expiration date of the contract, the expiration date, and the investor has bought a call, then said investor has purchased the option on the stock at a lower price and the option term expires with the investor profiting. Alas, a diagonal spread may also have the opposite result.
Diagonal spreads involve different options, but the underlying stocks are within the same class, A or B. Class A stock is common stock, available to the public, and carries 1 vote per share. Class B is commonly assigned at 10 votes per share and is usually reserved for the owners/founders of the issuing company so that they may retain control of the company.