Call Diagonal Spread Guide [Setup, Entry, Adjustments, Exit] (2024)

Call diagonal spreads consist of two call options. Call diagonals can be bullish or bearish depending on their setup.

Call diagonal spreads are bearish when a short call option is sold, and a long call option is purchased at a higher strike price and a later expiration date than the short call.

A bearish call diagonal spread is a combination of a call credit spread and a call calendar spread and is typically opened for a credit.

Bullish diagonal spreads, also known as a poor man's covered call, are typically opened for a debit.

This strategy guide focuses on bearish call diagonal spreads.

The strategy is successful if the underlying stock price is below the short call at the front-month expiration. The back-month long call option serves as protection and defines the strategy’s risk if the stock price is above the short call at the front-month expiration.

Call Diagonal Spread market outlook

A call diagonal spread is entered when an investor believes the stock price will be neutral or bearish short-term. The near-term short call option benefits from a decline in price from the underlying stock, similar to a bear call spread. The long call option will retain value better than a standard bear call spread because of its extended time horizon. An increase in volatility will also help add value to the long contract’s premium and potentially help offset a decline in value from the decreasing stock price.

The objective is for the underlying stock price to close below the short call option at the first expiration date. The short call option would expire worthless, and the long call option would still have extrinsic value. At this point, an investor could choose to close the long call option or continue to hold the position if they believe the stock will reverse and go higher. Another short call option could also be sold to bring in additional credit. The short contract would need to have the same expiration date as the long call. This would create a traditional spread position.

How to set up a Call Diagonal Spread

A call diagonal spread is a combination of a bear call credit spread and a call calendar spread. A call diagonal spread is created by selling-to-open (STO) a call option and buying-to-open (BTO) a call option at a higher strike price, with a later expiration date.

Call diagonal spreads are typically opened for a credit, though a debit may be paid. The pricing at entry is dependent on the width of the spread between the two strike prices and the time until expiration of the contracts. A tight spread width will result in a lower credit because the long option will be closer to the money and have more value. More time until expiration equates to more expensive options pricing and will also impact whether the position is opened for a debit or credit.

The width of the spread, minus the initial credit, is the maximum risk for the trade if the short call option is in-the-money and both options are closed at the front-month expiration. If the short call expires out-of-the-money, the long call may be sold for its extrinsic value. The credit received from selling the long call, plus the original credit received, will be the realized profit. The profit potential is unlimited if the short call expires worthless and the underlying stock price rises and/or implied volatility has a significant increase.

Call Diagonal Spread payoff diagram

The payoff diagram for a call diagonal spread is variable and has many different outcomes depending on when the options trader decides to exit the position. The maximum risk is defined at entry by the width of the spread minus the credit received.

If the stock price is above the short call at the front-month expiration, the option would need to be exited to avoid assignment. The long call may also be sold at the front-month expiration, or the investor could continue to hold the option if they believe the stock price will continue to increase. This would increase the maximum risk on the trade as the long call has the potential to expire out-of-the-money worthless.

If the stock price is below the short call strike at the front-month expiration--which is the diagonal spread goal--the short contract will expire worthless. The long call option will still have extrinsic time value. The investor can choose to exit the long call at this point or continue to hold the position.

For example, if a stock is trading at or below $50, and an investor believes the stock will stay below $50 in the near future, a call diagonal spread could be entered by selling a $50 call option and purchasing a $55 call option with a later expiration date. If the position collects $1.00 in credit, the max loss at the front-month expiration would be -$400.

The max potential profit will be variable and will depend on whether or not the long call is closed at the front-month expiration. However, if a credit is collected when the trade is entered, and the short call expires worthless, the $100 credit will be a guaranteed profit. The long call could be sold at the front-month expiration to create additional profit, or the long position could be held if the investor believes the underlying stock price will increase.

Entering a Call Diagonal Spread

A call diagonal spread consists of selling-to-open (STO) a short call option and buying-to-open (BTO) a long call option at a higher strike price and a later expiration date.

For example, suppose a stock is trading at or below $50, and an investor believes the stock will stay below $50 in the near future. In that case, a call diagonal spread could be entered by selling a $50 call option and purchasing a $55 call option with a later expiration date. The farther out-of-the-money the strike prices are at trade entry, the more bullish the outlook for the underlying stock price.

Exiting a Call Diagonal Spread

The decision to exit a call diagonal spread will depend on the underlying asset’s price at the expiration of the short call contract. If the stock price is below the short call, the option will expire worthless. The long call option will be out-of-the-money and have time value remaining. The extrinsic time value will depend on the length of time until expiration and the strike price relative to the stock price.

Time value, or theta, works against the long option, and the contract will lose value exponentially as it approaches expiration. A sell-to-close (STC) order will be entered when the investor wishes to exit the long call position. If the underlying stock price is above the short call at the first expiration date, both options may be closed to exit the position. This will result in the maximum loss on the trade.

If the investor chooses only to close the in-the-money short call option, more risk is possible. The stock could reverse, and the long call option will lose value. However, if the stock price were to increase, a profit could still be realized.

Time decay impact on a Call Diagonal Spread

Time decay, or theta, will positively impact the front-month short call option and negatively impact the back-month long call option of a call diagonal spread. Typically, the goal is for the short call option to expire out-of-the-money. If the stock price is below the short call at expiration, the contract will expire worthless. The passage of time will help reduce the full value of the short call option.

The time decay impact on the back-month option is not as significant early in the trade, but the theta value will increase rapidly as the second expiration approaches. This may influence the decision related to exiting the position.

Implied volatility impact on a Call Diagonal Spread

Implied volatility has a mixed effect on call diagonal spreads. The bear call spread component of the diagonal spread will be negatively impacted by increased implied volatility while the calendar spread will benefit. Ideally, the front-month short call option will expire out-of-the-money and be unaffected by changes in implied volatility. The position will experience the most profit if volatility is higher at the time of the second expiration. However, the stock price will need to be below the options’ strike price at the first expiration.

If implied volatility increases significantly early in the first expiration, the spread between the two contracts will decline. After the near-term expiration, the more implied volatility, the better. Higher implied volatility means there is a greater expectation of a large price change, which is ideal for the remaining long call position that is out-of-the-money when the first contract expires.

Adjusting a Call Diagonal Spread

Call diagonal spreads can be adjusted during the trade to increase credit. If the underlying stock price declines rapidly before the first expiration date, the short call option can be purchased and sold at a lower strike closer to the stock price. This will collect more premium, but the risk increases to the adjusted spread width between the strikes of the near-term expiration contract and long-term expiration contract if the stock reverses. If the short call option expires out-of-the-money, and the investor does not wish to close the long call, a new position may be created by selling another short call option.

The ability to sell a second call contract after the near-term contract expires or is closed is a key component of the call diagonal spread. The spread between the short and long call options would need to be at least the same width to avoid adding risk. Selling a new call option will collect more credit, and may even lead to a risk-free trade with unlimited upside potential if the net credit received is more than the width of the spread between the options.

Rolling a Call Diagonal Spread

The short call option of a call diagonal spread can be rolled lower if the underlying stock price drops. The short call may be purchased and resold at a lower strike price to collect more credit and increase profit potential. Ideally, the stock still closes below the short option, so it expires worthless. The long call option may have extrinsic value remaining to help reduce the loss or potentially make a profit.

Hedging a Call Diagonal Spread

Call diagonal spreads are not typically hedged. The strategy has a specific goal and defined risk. The position can be adjusted lower if the underlying stock price drops. The call diagonal spread holder may do nothing and continue to hold the position, let the near-term contract expire worthless, and see if the underlying security rises during the longer-term expiration. If the near-term contract is closed and a new contract is sold, the long call position may potentially be “free” if the combined credits of the two short contracts exceeds the debit required to enter the long call position. The reduced cost of the long call minimizes or eliminates the break-even point on the position.