Diagonal Call Spread
The Diagonal Call Spread is a rather versatile options trading strategy that brings together the features of both vertical and calendar spreads. It consists of buying a long-term call option at a lower strike price and selling a short-term call option at a higher strike price. This strategy is meant to exploit differences in time decay and strike price for potential profit, particularly in moderately bullish scenarios.
The Diagonal Call Spread Setup
Suppose you are examining stock XYZ, which is trading at $100. To implement a diagonal call spread, you could:
- Buy a long-dated call option with a strike price of $95 that expires in six months, for which you pay a premium of $10.
- Sell a short-dated call option with a strike price of $105 that expires next month, for which you receive a premium of $3.
Who Should Consider It
This strategy is suited for traders that expect a smooth increase in the stock’s price over time, but at the same time they want to have the accelerated time decay of the shorter-dated option. This strategy is meant for those searching for a less expensive way of having a bullish position while generating premium income offsetting the long call’s cost.
In the diagonal call spread, one desires the near call to expire worthless or get purchased back at a lower price; meanwhile, the far call has a value increasing with an increased stock price. The diagonal nature arises from different expiration dates and strike prices to allow for modification of the timing decay and the directional move.
The breakeven point is dynamic and depends on the time remaining until the expiration of the long call. It typically occurs when the total value of the long call offsets the initial net outlay (the cost of the long call minus the credit from the short call).
The sweet spot for this strategy occurs when the stock price is slightly below the strike price of the short call at its expiration. This will allow the short call to expire worthless, retaining the premium received, while the long call still retains significant time value and intrinsic value if the stock price is above its strike.
The maximum profit potential is not strictly capped but depends on how much the stock price exceeds the strike price of the long call after the short call expires. Profits can get very large if the stock really moves strongly above both strike prices after the short call’s expiration.
The maximum loss is capped at the net initial cost of the spread—the premium paid for the long call minus the premium received for the short call. This loss occurs if the stock price remains below the strike price of the long call and both options expire worthless.
The primary risk involves the stock not rising as expected, which could lead to a total loss of the net premium paid. Additionally, if the stock rises above the strike price of the short call before its expiration, the position may face unlimited loss potential unless managed properly.
In this strategy, time decay is nuanced. The short call being closer to expiry and out of the money decays faster than the long call. This typically favors the trader, especially when the short call is close to expiring.
This creates complex exposure of the position to changes in implied volatility because of the position involved in both calls and sells. Normally, increasing volatility favors a long call - that is more sensitive, in this case due to the increased duration and decreased strike.
A diagonal call spread is appropriate for traders that anticipate mild, medium-term bullish momentum, accompanied by the benefit of receiving premiums and differential time decay. This type of call spread can accommodate flexibility in controlling risk and aiming for substantial gains.