Multiple Trading Options with Neutral- Diagonal Call

A diagonal spread is an option spread that has multiple strike prices and expiration dates. In terms of strategy, a diagonal spread differs from a calendar spread in that purchasing the long-term option is less expensive because the strike price is further out of the money. Like a horizontal spread, the near option is typically sold on the shortened time decay over the last month of an option's term. The maximum profit, loss, and break-even points, like calendar spreads, can only be estimated because you cannot precisely know the time value of the options until the spread is closed out.

What Are Diagonal Spreads?

A diagonal spread is a customized calendar spread with multiple strike prices. It is an options strategy that involves taking a long and short position in two options of the same type (two call options or two put options) with different strike prices and expiration dates.

This strategy can be bullish or bearish depending on the structure and options used.

Understanding Diagonal Spreads

This strategy is so-called because it combines a horizontal spread (also known as a time spread or calendar spread) with a difference in expiration dates and a vertical spread (price spread) with a difference in strike prices.

You can refer to the positions of each option on an options grid as horizontal, vertical, and diagonal spreads. You will find the strike prices and expiration dates of options listed in a matrix, and vertical spread options are all listed in the same vertical column with the exact expiration dates. In the meantime, votes in a horizontal spread strategy use the same strike prices but have different expiration dates. As a result, the options are arranged horizontally on a calendar.

What is a Diagonal Bear Call Spread?

 Suppose you buy a higher strike call after selling the near-term call with a later expiration date, which results in a diagonal bear call spread. Most of the time, this results in a credit, which generates a profit when combined with the leftover time value of the long option at the short option expiration.

When the underlying price equals the long option's strike price, the short option is in the money due to the difference in strike prices, with no offset from the long option. As a result, the maximum loss will equal the difference in strike prices minus any remaining time value of the long option.

What is a Diagonal Bullish Call Spread?

A Long Call Diagonal Spread is designed to reduce cost by purchasing a long-term call and selling a near-term call on a further OTM strike. This trade has the directionality of a long vertical spread, and the positive vega of a calendar spread despite having only two legs. As a result, a bullish position will form, benefiting from increased implied volatility. A Long Call Diagonal Spread is typically used to simulate a covered call position.

Diagonal Spread Calls —Setup

You can consider this option to be a two-step strategy. It resembles a hybrid of a long calendar spread with calls and a short call spread. It begins as a time decay play. After selling a second call with strike A (after the front-month expiration), you have logged into a short call spread. Ideally, you will be able to implement this strategy for either a net credit or a small net debit. The sale of the second call will then be all gravy.

In this example, we'll look at one-month diagonal spreads. Please keep in mind that different time intervals are possible. If you want to use more than a one-month interval between the front-month and back-month options, you'll need to know how to roll an option position.

  • Sell an out-of-the-money call with a strike price of A (approximately 30 days from expiration – "front-month").

  • Purchase an additional out-of-the-money call with strike price B (about 60 days from expiration – "back-month").

  • When the front-month call expires, sell another call with strike A and the same expiration date as the back-month call.

  • In general, the stock will be lower than strike A.

Example for Diagonal Call with Longer Intervals

You can buy the option with the more extended expiration date and lower strike price and sell the option with the shorter expiration date and higher strike price in a bullish long call diagonal spread. For instance, consider purchasing one November ₹20 call option and simultaneously selling one November ₹25 call option.

Buy/Sell

Qty

Trade Date

Expiry Date

Strike

Type

Buy

+5

08/11/21

19/01/22

20

Call

Sell

-10

08/11/21

09/11/21

25

Call

Buy

10

09/11/21

09/12/21

25

Call

Sell

-5

9/11/21

18/01/22

30

Call

Who Should Execute the Diagonal Call Trading Options?

The diagonal call trading options strategy is not for beginners but for seasoned traders who know the ins and outs of trading with options. Veterans are those with years of expertise who can handle this strategy as dealing with options that expire on different dates requires a high level of knowledge and experience.

When to run the Diagonal Call?

The opportune time to run the diagonal call is when you expect neutral activity during the front month and then during the neutral activity to bearish activity during the back month.

Break-Even Point for Diagonal Call at Expiration

 You can only approximate the break-even points for the diagonal call at expiration because you must consider numerous variables to provide an accurate formula.

Because the options in a diagonal spread have two expiration dates, you need to use a pricing model to guess the value of the back-month call when the front-month call expires. You can use the Profit + Loss Calculator available online to assist you in this regard. 

However, keep in mind that the Profit + Loss Calculator assumes that all other variables, such as implied volatility, interest rates, and so on, will remain constant over the trade — which they may not in reality.

The Optimum Point for Diagonal Call

  • Step one is to keep the stock price at or near strike A until the front-month option expires.

  • Step two requires that the stock price be lower than strike A when the back-month option expires.

What is the Diagonal Call Maximum Profit Potential?

The potential profit is limited to the difference between the net credit received for selling both calls with strike A and the premium paid for the call with strike B.

It is necessary to remember that it is impossible to calculate potential profit at the outset because it is dependent on the premium received for the sale of the second call at a later date.

What is the Diagonal Call Maximum Loss Potential?

The risk limits itself to the difference between strike A and strike B, less the net credit received by establishing the net credit.

The risk is limited to the difference between strikes A and B, plus the net debit paid by establishing the net debit.

Because the premium received for the sale of the second call at a later date is dependent on the premium received for the sale of the first call at a later date, it is impossible to calculate your risk precisely at the outset.

Calculation of the Margin Requirement

When the position is closed at the expiration of the front-month option, the difference between the strike prices becomes the margin requirement.

Establish the net credit, and you can apply the proceeds to the initial margin requirement. Keep in mind that this is a per-unit requirement. But remember to multiply by the total number of units when doing the math.

Long Term Implications of Diagonal Call

Time decay is your ally in this strategy because the shorter-term call will lose time value faster than the longer-term call before the front-month expiration. After closing the front-month call with strike A and selling another call with strike A that expires at the same time as the back-month call with strike B, time decay is somewhat neutral. That's because the value of both the option you sold (good) and the option you bought (bad) will erode (bad).

Conclusion

The most basic application of a diagonal spread is to close the trade when the shorter option expires. On the other hand, "roll" the strategy, most frequently by substituting the expired option with an option with about the same strike price but expiration date as the more extended option (or earlier).