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Educational Article

The Diagonal Spread

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There are many ways derivatives can be employed to leverage capital or reduce risk. Although most traders simply buy and sell call options, those who want to participate in all types of market environments must learn other, more versatile techniques in order to realize consistent profits. Because stock prices are rarely predictable, it is absolutely essential to completely understand the various strategies used to limit potential losses from unexpected activity. One of the methods commonly employed to achieve this objective involves combinations of long and short options or "spreads."

Spreads may seem complex but once broken down into separate components, they are relatively easy to comprehend. Though spread trades involve individual options with different strike prices and expiration dates, the fundamental concepts of calls and puts are retained and the desired outcome can usually be accomplished by approaching each situation from a practical viewpoint. Even when utilized in a more advanced manner, the resulting position is always some form of vertical or horizontal spread, straddle, or combination. While novice traders typically avoid these strategies, experienced players use countless variations of each technique to profit from different types of movement or character in the underlying market. When the trend is primarily directional, a vertical spread is often initiated. In contrast, when the character of the underlying issue is range-bound and less volatile, a horizontal spread may be used. Then again, when the traits of both vertical and horizontal spreads are necessary in one position, the preferred strategy usually is a diagonal spread.
 

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