General Securities Representative (Series 7) Practice Exam

What defines a diagonal spread in options trading?

1. Only different expiration months

2. Only different strike prices

3. Different strike prices and expiration months

4. Same expiration and different strike prices

The correct answer is: Different strike prices and expiration months

A diagonal spread in options trading is defined by the use of different strike prices and different expiration months. This strategy involves buying and selling options with various characteristics to create positions that can potentially benefit from a change in the price of the underlying asset as well as from time value differences between the options involved. In constructing a diagonal spread, traders exploit the volatility and time decay associated with options. By combining options that have different expiration dates, the trader is able to take advantage of changes in the time value and underlying price movements over the life of the options. The differing strike prices allow for more granular control over the risk and potential reward of the position. This spread strategy can be used in a variety of market conditions, as it combines elements of both vertical spreads (which involve different strike prices but the same expiration) and calendar spreads (which involve different expiration dates but the same strike prices). By including both variables, diagonal spreads provide a flexible approach to managing risk and capitalizing on movements in the underlying asset.