Despite not being advocated as a mainstream option strategy, the diagonal call spread is easy to understand, particularly if you are familiar with covered calls. It is initiated by opening long and short option positions with different strike prices and expiration dates. Some investors use it as a way of generating greater returns than a covered call strategy, as the long stock position is replaced with a deep in-the-money long dated call option. This long dated call option will have a high delta and behave similar to a long stock position.
This type of spread is beneficial when investors are predicting that market will stay bullish in the longer term and mildly bullish for shorter term. Let’s use GE as an example. With the stock trading at around $19 in April, we would purchase a December $10 call and sell a May $20 call. If this example, the trader would be bullish on the stock but would not want it to rise to much further than $20, as profits will start to decrease after this point, albeit slowly. This can be seen in the below payoff diagram for this trade.
With diagonal call spreads, there is limited upside due to the sold call option. Risks are limited to the amount paid for the spread, which would be the cost of the long call option less the sold call. Even though diagonal call spreads have a similar payoff diagram to a covered call the risks are less. This is because, the trader is paying less for the long call than they would for the stock. Let’s use our theoretical example of a stock trading at $18. In a covered call strategy, the trader would have to purchase 100 shares at $18 = $1800. The diagonal call spread trader could purchase a long dated $10 call option that would cost somewhere in the vicinity of $9 = $900. If the stock falls to zero, the covered call trader loses $1800 (less the premium received for the sold call) and the diagonal trader losses only $900 (less the premium received for the sold call).
Breakeven Point at Expiration Date
It is hard to calculate exact breakeven point in advance due to the different variables at play, the best we can do is use a profit and loss calculator to get a best guess of the breakeven point. These calculators normally consider factors such as interest rates and implied volatility to remain constant for the term of options when the reality is much different, but they do give us a decent estimation.
When things go smoothly with a diagonal call spread, and as soon as the ‘near month’ call expires, the trader can choose to write another call and keep writing call options each month until the long term call expires. This process is repeated frequently to generate monthly income and continually reduce the cost of the long call. Alternatively, if the trader has changed his stance to very bullish, he could simply hold on to the long call after the short call expires. The short call can be seen as helping to pay for some of the cost of the long call. However, if the trader chooses to do this, the exposure is greatly increased by holding only the long call. Using the GE example from above the net delta of the spread is 67, meaning the exposure is equivalent to owning 66 shares, however if you remove the short call, the delta increases to 92.
When to Roll the Sold Call
The other consideration with regards to this strategy is when to roll the sold call. Those traders familiar with covered calls will find the process very similar. If the stock rises significantly, you need to decide whether you want to take your profits and close the position, or roll the sold call up to a higher strike and increase your exposure to the stock. If the stock falls, you will need to decide whether to cut your losses or roll the sold call down to a lower strike. Rolling down brings in some extra income to offset the losses from the long call. A good way to decide on your strategy for rolling, is with the use of delta to ensure that you are comfortable with your overall exposure to the stock at all times.
Implied volatility is a much more important consideration for diagonal call spread traders than it is for covered call traders. Covered call traders only have exposure to volatility via the short call, whereas the diagonal trader has exposure on the both the short and long call options. Diagonal traders need to be much more aware of how changes in implied volatility will affect their position. The diagonal trade is a long volatility trade due to the fact that the exposure to volatility will be greater on the long call than it is on the short call. Exposure to volatility will also begin to increase as the short call gets closer to expiry as the Vega of the short call will reduce while the Vega of the long call will remain roughly the same.
Let’s again look at our GE example. Entering the trade on April 16th gives us the following greek values, you can see that Vega is 0.53. Assuming no change in the stock price, vega will jump to 1.93 once the short call expires. This may not sound like a lot, but keep in mind this is for just 1 contract.
Opening Trade on April 16th
At expiration of the sold call assuming no change in price
Another consideration with this strategy is commission costs. It is recommended that you choose a low commission broker to trade this spread. If you decide to keep rolling the sold call, you will be incurring commission costs each month. If you are only bringing in say $80 in income, but paying $10 – $20 in commissions, this erodes a significant portion of the income from the sold call. Optionshouse and Interactive Brokers are two brokers that that I highly recommend.
a) Buy an in-the-money call with strike price A. This is a back-month call with at least 60 days to expiration.
b) Sell an out-of-themoney call with strike price B. This is a front-month call with expiration in around 30 days.
c) At the time the front-month option expires, sell another call with strikes to be determined by the current stock price and / or delta. OR, hold on to the long call if the trader has changed his opinion on the stock to very bullish.
The Best Case Scenario
The maximum profit from this strategy will be if the stock price finishes at or around the strike price B at the expiration of the sold call. Ideally, there would also be some rise in implied volatility which would result in further gains.
As with all option strategies, a key factor you need to take into consideration is how difficult they will be in terms of time management. If you are a part time trader you do not want to be trading strategies that require constant monitoring during the day. The diagonal call spread is similar in nature and therefore, time management requirements to a covered call. You should not need to monitor it more than every 1 to 2 days.
Here’s to your ultimate success!