Let’s take a look at this dynamic strategy.

Contents
 Introduction
 Maximum Loss
 Maximum Gain
 Breakeven Price
 Payoff Diagram
 Risk of Early Assignment
 How Volatility Impacts Diagonal Call Spreads
 How Theta Impacts Diagonal Call Spreads
 Other Greeks
 Risks
 Diagonal Call Spread vs Diagonal Put Spread
 Diagonal Call Spread vs Covered Call
 Trade Management
 Examples
 Summary

Introduction
There are actually two types of diagonal call spreads we’ll cover today, the first is the
standard version which is sometimes called a poor man’s covered call which
was covered in detail here.
These are easy if you are familiar with covered calls.
It is initiated by buying a long-term in-the-money call and selling a short-term out-of-the-
money call.
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.
The second type is where the trader sells a near term out-of-the-money call and then
buys a longer-term call that is further out-of-the-money.
Here’s an example of how that looks and this is the type we will discuss in detail in this
article.

Maximum Loss
If the stock drops, the maximum loss is limited to the debit paid to enter the trade.
Sometimes, the near-term options is sold for a higher price than the longer dated option.
In this case, there is no loss on the downside and if the stock is below both call strikes
at expiry, they both expire worthless and trade would actually be in profit by the amount
of the credit received for opening the trade.
If the stock rallies, the maximum loss on the upside is equal to the difference in the
strike prices plus / minus the option premium paid / received.
In the TWTR example above, the strikes are $2 apart and there are two contracts, so
that makes a $400 potential loss, plus the $26 in premium paid for a total maximum
potential loss of $426.

Maximum Gain
The maximum gain on a diagonal spread can’t actually be worked out in advance
because it’s impossible to know what the back-month option will be trading for when the
front-month option expires.
This is due to changes in implied volatility.
The best we can do is use our broker platform or software such as Option Net
Explorer to estimate the maximum gain.
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In our TWTR example, the maximum gain is estimated at just over $200.
The ideal scenario for the trade is that the stock ends near the short strike at the
expiration of the near-term option.
Ideally this would be associated with an increase in implied volatility in the back-month
option.
The increase in implied volatility in the back-month helps to offset any negative effects
from time decay.
Some traders like to hold the long call as a stand-alone trade after the short call expires.
The expired short call helps offset the cost of the long call.

Breakeven Price
Like the maximum gain, the exact breakeven price can’t actually be calculated but we
can estimate it.
Looking at the TWTR example, we can see that the breakeven points are estimated
around $32 and $38.80.
If the trade is entered for a net credit, there will be no breakeven price on the downside.
See example below:
Payoff Diagram
Diagonal call spreads have low risk on the downside and a tent shaped profit zone on
the upside, with all the risk in the trade being above the profit tent.
For this reason, a big rally in the stock early in the trade is the worst case scenario.
Using our TWTR example, we can see how the trade performs over different time
periods by looking at the T+0, T+5 and T+10 lines.
Notice that an initial rally up to $36 will see the trade in a loss situation, but if that level
is reached on day 5-10, the trade is actually in profit.
Losses start to accelerate if the stock breaks through the short strike, so for this reason,
it is best to close the trade before the stock breaks above that level.
Risk of Early Assignment
There is always a risk of early assignment when having a short option position in an
individual stock or ETF. You can mitigate this risk by trading Index options, but they are
more expensive.
Usually early assignment only occurs on call options when there is an upcoming
dividend payment. Traders will exercise the call in order to take ownership of the share
before the ex-date and receive the dividend.
For this reason, it’s important to watch out for ex-dividend dates. Otherwise, make sure
to close the trade before the short call goes in-the-money and this will help avoid early
assignment.

How Volatility Impacts Diagonal Call

Spreads
Diagonal spreads are long vega trades, so generally speaking they benefit from rising
volatility after the trade has been placed.
Vega is the greek that measures a position’s exposure to changes in implied volatility. If
a position has negative vega overall, it will benefit from falling volatility.
If the position has positive vega, it will benefit from rising volatility. You can read more
about implied volatility and vega in detail here.
Our TWTR example starts with a vega of 2. This means that for every 1% rise in implied
volatility, the trade should gain $2.
The opposite is true if implied volatility drops 1% – the position would lose $2.
Here’s how the TWTR trade looks assuming a 10% rise in implied volatility.
Notice that the expiration line maximum profit has rises from around $200 to over $250
and all three of the interim lines have also been lifted up.
The opposite is true if we estimate a 10% drop in volatility, the whole payoff graph has
now moved downwards with a maximum potential profit of only $125.
It’s important to note that the maximum potential loss has not changed.

How Theta Impacts Diagonal Call

Spreads
Diagonal spreads are positive theta trades in that they make money as time passes,
with all else being equal.
This is due to the fact that the short call suffers faster time decay than the bought call.
This is especially true if the bought call is much further out in time (I.e. more than just
one month).
In our TWTR example, the trade has positive Theta of 13.
This means that, all else being equal, the trade will gain $13 per day due to time decay.
Notice that the positive time decay on the short-term sold call is higher than the time
decay being suffered on the longer-dated long call.

Other Greeks
DELTA
Delta on a diagonal spread is generally going to be negative to start with and we can
see that in our TWTR (-2) and BA (-8) examples.
As the trade progresses, the delta will change.
For example, if TWTR drops below $33, the trade actually flips to be slightly positive
delta, because the trader wants the stock to head back up towards the profit zone as
the trade gets closer to expiry.

GAMMA
Diagonal spreads are negative gamma. Generally any trade that has a profit tent above
the zero line will be negative gamma because they will benefit from stable prices.
Gamma is one of the lesser known greeks and usually, not as important as the others.
I say usually, because you’ll see further down in this post why it can be really important
to understand gamma risk.
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Diagonal spreads maintain a bit of a natural hedge because they are negative gamma,
but positive vega. The ideal scenario is that implied volatility rises (good for positive
Vega) but realized volatility remains low (good for negative gamma).
In other words you want the stock to stay relatively flat, but show a rise in implied
volatility (the expectation of future big price moves).
In our TWTR example the initial diagonal had -5 gamma while the BA trade has almost
0 gamma.

Risks
The main risk with the trade is a sharp rally in the underlying stock early in the trade.
A rally late in the trade can be ok, provided the stock doesn’t break through the short
call.

ASSIGNMENT RISK
We talked about this already so won’t go into to much detail here and while this doesn’t
happen often it can theoretically happen at any point during the trade.
The risk is most acute when a stock trades ex-dividend.
If the stock is trading well below the sold call, the risk of assignment is very low.
E.g. a trader would generally not exercise his right to buy TWTR at $37 when TWTR is
trading at $33. For a stock like
TWTR that doesn’t pay a dividend, the risk of early assignment is quite low but that
would be different when using this strategy on a stock that does pay a dividend.
Assignment risk is highest if the stock is trading ex-dividend and the short call is in the
money.
One way to avoid assignment risk is to trade stocks that don’t pay dividends, or
trade indexes that are European style and cannot be exercised early.
The risk is also very low if the short calls are out-of-the-money.
To reduce assignment risk consider closing your trade if short call is close to being in-
the-money, particularly if it is close to expiry.

EXPIRATION RISK
Leading into expiration, if the stock is trading just above or just below the short call, the
trader has expiration risk.
The risk here is that the trader might get assigned and then the stock makes an adverse
movement before he has had a chance to cover the assignment.
In this case, the best way to avoid this risk is to simply close out the spread before
expiry.
While it might be tempting to hold the spread and hope that the stock drops and stays
below the short call, the risks are high that things end badly.
Sure, the trader might get lucky, but do you really want to expose your account to those
risks?
VOLATILITY RISK
As mentioned on the section on the greeks, this is a positive vega strategy meaning the
position benefits from a rise in implied volatility.
If volatility falls after trade initiation, the position will likely suffer losses.
The other risk with volatility relates to the volatility curve.
Generally speaking, when volatility rises or fall it has a similar impact across all
expiration periods.
However, you could potentially run into a scenario where volatility in the front month
rises (bad for the short call) and volatility in the back month drops (bad for the long call).
That would result in a double whammy for the trade.
That scenario may not be that common but it could happen and it’s important that trades
understand volatility term structure when placing trades that span different expiration
periods.

Diagonal Call Spread vs Diagonal Put

Spread
The opposite of a diagonal call spread is a diagonal put spread. With a put spread, the
risk and also the profit tent are on the downside.
Here’s what a diagonal put spread would look like:
Diagonal put spreads have a lot of similarities with put ratio spreads.

Diagonal Call Spread vs Covered Call

As mentioned at the start of this article, there are two different types of diagonal call
spreads and in this article we have focused on the second type rather than the poor
man’s covered call.
The poor man’s covered call is very similar to a regular covered call but uses an in-the-
money long call in place of the stock.
This allows the trader to enter the trade with much less capital at risk and still potentially
achieve a similar dollar return.
The diagonal call spread that we have looked at in this article is very different to a
covered call.

Trade Management
As with all trading strategies, it’s important to plan out in advance exactly how you are
going to manage the trade in any scenario.
What will you do if the stock rallies? What about if it drops? Where will you take profits?
Where and how will you adjust? When will you get stopped out?
Lot’s to consider here but let’s look at some of the basics of how to manage diagonal
spreads.

PROFIT TARGET
First and foremost, it’s important to have a profit target.
That might be 10% of capital at risk or you may plan on holding to expiration provided
the stock stays within the profit tent. Ten to fifteen percent is a good target for a trade
like this.

STOP LOSS
Having a stop loss is also important, perhaps more so than the profit target.
With diagonal spreads, you can set a stop loss based on percentage of the capital at
risk. In this case it might be closing the trade if the loss reaches 15-20%.

Examples
Let’s see what actually happened in our Twitter (TWTR) diagonal call spread.
Date: Jun 12, 2020
Price: $33.37
Sell two Jun 26 TWTR $37 call @ $0.402
Buy two Jul 17 TWTR $39 call @ $0.533
Total Debit: $26
Max Risk: $426
Investor plans to take profit at 15% of max risk, or $64.
Investor plans to exit if loss 20% of max risk, or $85.
Neither of these levels was reached. On Jun 26 expiration, TWTR closed at $29.05
when the short call expired worthless out-of-the-money.
The investor sells the remaining two long call for $13.
The net loss to the investor about $13, more or less depending on fills and
commissions.

Summary
Diagonal call spreads are a neutral trade that can handle a move higher in the stock
provided the move isn’t too big or too early in the trade.
For this reason they should only be placed on stocks the trader thinks might move
slightly higher but not too much higher.
A good time to enter this type of trade is at the end of a strong bull move where further
upside is likely to be limited.
Given that the position contains options across multiple expiration dates, it’s important
to have a solid grasp of implied volatility including how volatility changes impact options
with different expiration periods.
One nice feature of the trade is that there is very little risk on the downside and in some
instances, even the ability to generate a small amount of premium if both calls expire
worthless.