Diagonal Spreads

A diagonal spread combines features of a vertical spread and a calendar spread. You buy an option with a later expiration and sell an option with an earlier expiration at a different strike. Diagonals let traders build a directional bias into a time decay trade. The best known version, often called the poor man's covered call, uses a long dated in the money call as a substitute for shares and sells short dated calls against it for income.

Construction#

• Bullish call diagonal: buy a longer dated lower strike call, sell a shorter dated higher strike call.
• Bearish put diagonal: buy a longer dated higher strike put, sell a shorter dated lower strike put.

How it makes money#

• Time decay: the short near term option decays faster than the long option. See Theta.
• Direction: the long option usually has a higher delta than the short, so the position benefits from moves towards the short strike. See Delta.
• Volatility: the long option has more vega, so rising implied volatility helps. See Vega.
• Repeated income: after each short option expires, a new one can be sold against the same long option.

The poor man's covered call#

A covered call requires owning 100 shares. A poor man's covered call replaces the shares with a deep in the money long dated call (often 0.70 to 0.85 delta, expiring in 6 to 18 months) and sells short dated out of the money calls against it.

Key rule: avoid a net debit larger than the width#

For a call diagonal, if the net debit paid exceeds the difference between the strikes, a sharp rally through the short strike can produce a loss even though you were right on direction. In the example, the width is $105 minus $80 = $25 and the net debit is $24.00 minus $1.50 = $22.50, so a rally is still profitable.

Diagonal vs calendar vs vertical#

See Vertical Spreads and Calendar Spreads.

Managing a diagonal#

• Roll the short option each cycle, choosing a strike above the current price for a bullish diagonal.
• If the stock rallies past the short strike, roll the short call up and out, or close the whole spread.
• If the stock falls, you may sell lower strike calls, but avoid selling below the level that locks in a loss if called.
• Watch the long option's time left; roll it to a later expiry before its time decay accelerates.

Risks#

• Large declines: the long option can lose much of its value.
• Sharp rallies: profit is capped until the short option is rolled.
• Volatility collapse reduces the long option's value.
• Early assignment of the short option. See Exercise and Assignment.
• No dividends: unlike shares, the long call does not receive dividends.

Frequently asked questions#

What is a diagonal spread?#

An options spread that buys and sells options of the same type with different strikes and different expirations.

What is a poor man's covered call?#

A diagonal spread that buys a deep in the money long dated call and sells short dated out of the money calls against it, imitating a covered call with less capital.

Is a diagonal spread bullish or bearish?#

It can be either. A call diagonal with a lower long strike is bullish; a put diagonal with a higher long strike is bearish.

Next, learn to profit from a range with the Iron Condor.