Diagonal Call Spread
The Setup
Consider you're analyzing stock XYZ, currently priced at $100. To execute a diagonal call spread, you might:
- Buy a long-term call option with a strike price of $95 expiring in six months, costing you a premium of $10.
- Sell a short-term call option with a strike price of $105 expiring next month, receiving a premium of $3.
Who Should Consider It
This strategy is ideal for traders who expect a gradual increase in the stock's price over time but also want to benefit from the accelerated time decay of the shorter-dated option. It's suited for those looking for a cost-effective way to have a bullish position while also earning premium income to offset the cost of the long call.
Strategy Explained
In a diagonal call spread, the goal is to have the short-term call expire worthless or be repurchased at a lower price, while the long-term call gains value as the stock price increases. The diagonal element comes from the different expiration dates and strike prices, allowing traders to adjust their exposure to time decay and directional movements.
Breakeven Process
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).
Sweet Spot
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 allows 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.
Max Profit Potential
The maximum profit potential is not strictly capped but is influenced by how much the stock price exceeds the strike price of the long call after the short call expires. The profit can grow substantially if the stock makes a strong move above both strike prices after the short call's expiration.
Max Loss
The maximum loss is limited to 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.
Risk
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.
Time Decay
Time decay (theta) is nuanced in this strategy. The short call, being closer to expiration and out of the money, will experience faster decay than the long call. This generally benefits the trader, especially as the expiration of the short call nears.
Implied Volatility
Since the position involves both buying and selling calls, its exposure to changes in implied volatility is complex. Typically, an increase in volatility is more favorable for the long call (more sensitive due to a longer duration and lower strike), potentially increasing the overall value of the position.
Conclusion
A diagonal call spread is a strategic choice for traders expecting moderate bullish momentum over time combined with the opportunity to benefit from premium income and differences in time decay. Its configuration allows for flexibility in managing risk while aiming for substantial potential gains.