A diagonal spread with calls is a position made up of buying one long-term call at a lower strike price and selling a shorter-term call at a higher strike price. The position is somewhat of a cross between a long calendar spread with calls and a covered call. The ideas is that a trader wants to sell upside calls, but still keep themselves safe in case the stock runs up.

If executed correctly, the trader can continue to sell upside calls against their long further out call. So, when one short-term call expires, the trader can sell another short-term call, set to expire in the following month, and can continue to do this up until the final month, when the long call is set to expire.

Profit/Loss

The maximum profit is calculated by adding up all the premiums received from selling short-term upside calls, minus the initial premium to execute the trade, plus the stock price minus the strike price on the final month.

The maximum loss for a diagonal call spread is limited to the cost of the trade, which is met when the stock trades down under the long-term call strike price.

Breakeven

Because this is a dynamic trade with many possible scenarios and future trades, it is impossible to calculate a breakeven.

Example

If XYZ is trading $100 and is expected to trade higher over the next four months a trader could buy the June 100 call for $4 and then sell the April 105 call for $1.25, resulting in an initial cost of $2.75.

If the stock trades up to $103 by April expiration, then the April call is removed from the account, and the trader has made a gain on the long call. They could then sell a May 105-strike call for $1.75. If the stock trades up to $105 by May expiration, then the trader banks the $1.75 and also has $5 of intrinsic value in the long-term call. They could then sell a June 110 call for $1.25. If the stock trades up to $108 by June expiration, then the June call will also expire worthless. Here the trader would have paid a premium of $2.75 to open the trade, then pocked premiums of $1.75 and $1.25 along the way. They would also have $8 of intrinsic value in the stock. This would result in a total profit of ($8+$1.75+$1.25-$2.75) = $8.25.

If however, the stock fell to $90 after the initial trade, both options would drop too much in value, making moving forward with the strategy impossible. If the stock never traded higher, then both options would expire worthless and the trader would lose their $2.75.

Conclusion

This is more of an advanced strategy that sets to capitalize on short-term higher volatility. It works best if the stock trades up, but slowly over time. That, of course, can be tricky when the strategy is mostly about capturing volatility.

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ChrisDouthit
ChrisDouthit

The founder of OptionStrateigesInsider.com has a long history with options and an extensive education in finance. Holding an MBA and multiple finance degrees, Chris has put in the time and effort to learning the market fundamentals.