Diagonal Bull Call Spread Explained

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Diagonal Bull Call Spread

The diagonal bull call spread strategy involves buying long term calls and simultaneously writing an equal number of near-month calls of the same underlying stock with a higher strike.

This strategy is typically employed when the options trader is bullish on the underlying stock over the longer term but is neutral to mildly bullish in the near term.

Diagonal Bull Call Spread Construction
Buy 1 Long-Term ITM Call
Sell 1 Near-Term OTM Call

Limited Upside Profit

The ideal situation for the diagonal bull call spread buyer is when the underlying stock price remains unchanged and only goes up and beyond the strike price of the call sold when the long term call expires. In this scenario, as soon as the near month call expires worthless, the options trader can write another call and repeat this process every month until expiration of the longer term call to reduce the cost of the trade. It may even be possible at some point in time to own the long term call “for free”.

Under this ideal situation, maximum profit for the diagonal bull call spread is obtained and is equal to all the premiums collected for writing the near-month calls plus the difference in strike price of the two call options minus the initial debit taken to put on the trade.

Limited Downside Risk

The maximum possible loss for the diagonal bull call spread is limited to the initial debit taken to put on the spread. This happens when the stock price goes down and stays down until expiration of the longer term call.

Example

In June, an options trader believes that XYZ stock trading at $40 is going to rise gradually for the next four months. He enters a diagonal bull call spread by buying a OCT 40 call for $300 and writing a JUL 45 call for $100. The net investment required to put on the spread is a debit of $200.

The stock price of XYZ goes up by $1 a month and closes at $44 on expiration date of the long term call. As each near-month call expires, the options trader writes another call of the same strike for $100. In total, another $300 was collected for writing 3 more near month calls. Additionally, with the stock price at $44, the OCT 40 call expires in the money with $400 in intrinsic value. Thus, in total, his profit is $400 (intrinsic value of the OCT 40 call) + $300 (additional call premiums collected) – $200 (initial debit) = $500.

If the price of XYZ had declined to $38 and stayed at $38 until October instead, both options expire worthless. The trader will also be unable to write additional calls since they are too far out-of-the-money to bring in significant premiums. Hence, he will lose his entire investment of $200, which is also his maximum possible loss.

Suppose the price of XYZ did not move and remains at $40 until expiration of the long term call, the trader will still profit as the total amount of premium collected is $400 while the OCT 40 call cost $300, resulting in a $100 profit.

Note: While we have covered the use of this strategy with reference to stock options, the diagonal bull call spread is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

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Similar Strategies

The following strategies are similar to the diagonal bull call spread in that they are also bullish strategies that have limited profit potential and limited risk.

Diagonal Option Spreads

A diagonal spread is an option spread with different strike prices and expiration dates. A diagonal spread differs from a calendar spread, as far strategy goes, in that purchasing the far term option is less expensive because the strike price is more out-of-the-money. As with a horizontal spread, the near option is generally sold to take advantage of the faster time decay in the last month of an option’s term. Like calendar spreads, and unlike the closely related vertical spreads, the maximum profit, maximum loss, and breakeven points can only be estimated, since the time value of the options cannot be known for certainty until spread is closed out.

An advantage of diagonal spreads, as with horizontal spreads, that have additional expiration dates between the short and long option is that a spread can be reestablished when the near-term option expires by selling another short option that expires later, but before the expiration of the long option.

Generally, the long side of the spread would expire later than the short side of the spread, especially if the use of margin is to be minimized. If the long option has an earlier maturity date then the short option, then most brokers will require sufficient margin to cover the short option.

Like most spreads, diagonal spreads lowers potential profits, but also lowers potential losses. The maximum profit is generally earned when the underlying asset price is near the strike price of the written option at its expiration.

There are several types of diagonal spreads that are closely related to vertical spreads. A diagonal bull spread is one that increases in value when the price of the underlying increases, while a diagonal bear spread is one that increases in value as the price of the underlying decreases.

There are many possibilities to a spread, so to simplify this discussion, this article will analyze potential profits and losses when the short option expires. The maximum profit from the diagonal bull call spread and the diagonal bear put spread is equal to the difference in strike prices plus any remaining time value of the long option minus the debit that must be paid to establish the spread; the debit is also the maximum loss. The maximum profit for the diagonal bear call spread and the diagonal bull put spread is equal to the credit received when establishing the spread plus any remaining time value of the long option; the maximum loss will be equal to the difference in strike prices plus the credit received plus the time value of the remaining long option.

Diagonal Debit Spreads

A diagonal bull call spread is established by selling a call and buying a call with a lower strike price that expires later.

Diagonal Debit Spread Profit/Loss

Stock Price Profit/Loss
Both options OTM = 0 – Debit Maximum loss: all options expire worthless.
Long Option ITM = |S – K1| – Debit The value of the spread increases by $1 for each $1 increase in the underlying.
Both Options ITM = |K2 – K1| – Debit
+ TV of long option.
Maximum profit: When the stock price = strike of short option, where TV will be at a maximum, while still earning the full difference between the strikes. The ITM long and short options offset each other as they become more ITM: the strike difference will still be earned, but TV will diminish at greater ITM prices.
  • S = Price of Stock or Other Underlier
  • K1 = Lower Strike
  • K2 = Higher Strike
  • |x| = Absolute Value of x, so |-x| = x.

If the price of the underlying is below both strike prices, then the profit or loss will be determined by the difference in the remaining time value of the long call and the debit paid to establish the spread.

Important Note: I strive to keep all the articles on my website up to date, but I continue to use older examples if they continue to illustrate current principles or law. Using newer dates in these examples will not improve their illustrative value, but it would increase the amount of work that I would continually have to do. I update everything that is important, but these option examples are based on timeless principles, so no pedagogical value would be added by using newer dates.

Examples: Diagonal Bull Call Spreads
SPY SPDR S&P 500 ETF Trust
Date 8/29/2020
Underlying Price 200.71
Call Strike Price
Sell Sep-14 200 $2.24
Buy Nov-14 198 -$3.72
Profit/Loss Analysis at Expiration of Short Option
Debit -$1.48
Maximum Profit $2.00 + Remaining Time Value of Long Option
Actual Profit/Loss at Expiration of Short Option on 9/19/2020
SPY 200.70
Buy Sep-14 200 -$.70
Sell Nov-14 198 $5.46
Actual Profit After Subtracting Debit $3.28
FB Facebook
Date 8/29/2020
Underlying Price 74.82
Call Strike Price
Buy Oct-14 72.5 -$4.30
Sell Sep-14 75 $1.95
Profit/Loss Analysis at Expiration of Short Option
Debit -$2.35
Maximum Profit $2.50 + Remaining Time Value of Long Option
Actual Profit/Loss at Expiration of Short Option on 9/19/2020
FB 77.91
Buy Sep-14 75 -$2.91
Sell Oct-14 72.5 $5.25
Actual Loss After Subtracting Debit -$0.01

A diagonal bear put spread is established by buying the far option put with a higher strike price and selling the near option put with a lower strike price, which like the bull call spread will require a debit to be paid, with a maximum profit equal to the difference in strike prices plus any remaining time value of the long option minus the debit paid.

Examples: Diagonal Bear Put Spreads

SPY SPDR S&P 500 ETF Trust
Date 8/29/2020
Underlying Price 200.71
Put Strike Price
Buy Nov-14 200 -$3.03
Sell Sep-14 198 $1.70
Profit/Loss Analysis at Expiration of Short Option
Debit -$1.33
Maximum Profit $2.00 + Remaining Time Value of Long Option
Actual Profit/Loss at Expiration of Short Option on 9/19/2020
SPY 200.70
Expired Worthless Sep-14 198 $0.00
Sell Nov-14 200 $3.20
Actual Profit After Subtracting Debit $1.87
FB Facebook
Date 8/29/2020
Underlying Price 74.82
Put Strike Price
Buy Oct-14 72.5 -$1.95
Sell Sep-14 70 $0.51
Profit/Loss Analysis at Expiration of Short Option
Debit -$1.44
Maximum Profit $2.50 + Remaining Time Value of Long Option
Actual Profit/Loss at Expiration of Short Option on 9/19/2020
FB 77.91
Buy Sep-14 70 -$7.91
Sell Oct-14 72.5 $5.25
Actual Loss After Subtracting Debit -$4.10

Diagonal Credit Spreads

A credit is earned when a call spread is established, by selling a more at the money option and buying a more OTM option. However, because the time value adds to the cost of buying the far option, a credit can only be earned when the short option has significant intrinsic value, meaning that it must be in the money. The maximum profit is earned when the near option expires worthless and the far option has significant time value remaining. The maximum loss will be equal to the difference in the strike prices plus the credit earned plus the time value of the remaining long option.

A diagonal bear call spread is set by selling the near-term call and buying a higher strike call with a later expiration date. This generally results in a credit, which when added to the remaining time value of the long option at the expiration of the short option yields a profit. The maximum loss is incurred when the underlying price is equal to the strike price of the long option, in which case, the short option is in the money by the difference in the strike prices with no offset from the long option. Hence, the maximum loss will be equal to the difference in strike prices minus the remaining time value of the long option, if any.

Examples: Diagonal Bear Call Spreads

SPY SPDR S&P 500 ETF Trust
Date 8/29/2020
Underlying Price 200.71
Call Strike Price
Buy Nov-14 200 -$3.10
Sell Sep-14 198 $3.72
Profit/Loss Analysis at Expiration of Short Option
Credit $0.62 + Remaining Time Value of Long Option
Maximum Loss $2.00 + Remaining Time Value of Long Option
Actual Profit/Loss at Expiration of Short Option on 9/19/2020
SPY 200.70
Buy Sep-14 198 -$2.70
Sell Nov-14 200 4.07
Actual Profit After Adding Credit $1.99
FB Facebook
Date 8/29/2020
Underlying Price 74.82
Call Strike Price
Buy Oct-14 75 -$2.90
Sell Sep-14 70 $5.15
Profit/Loss Analysis at Expiration of Short Option
Credit $2.25 + Remaining Time Value of Long Option
Maximum Loss $5.00 + Remaining Time Value of Long Option
Actual Profit/Loss at Expiration of Short Option on 9/19/2020
FB 77.91
Buy Sep-14 70 -$7.91
Sell Oct-14 75 $2.97
Actual Loss After Adding Credit -$2.69

A diagonal bull put spread is set by selling the near-term ITM put and selling the longer-term OTM put. Like the bear call spread, the maximum profit is earned when the price of the underlying is at the strike price of the short option at expiration, leaving the credit plus the time value of the long option as a profit.

Examples: Diagonal Bull Put Spreads

SPY SPDR S&P 500 ETF Trust
Date 9/3/2020
Underlying Price 200.44
Call Strike Price
Sell Sep-14 203 $3.64
Buy Oct-14 200 -$3.26
Profit/Loss Analysis at Expiration of Short Option
Credit $0.38 + Remaining Time Value of Long Option
Maximum Loss -$3.00 + Remaining Time Value of Long Option
Actual Profit/Loss at Expiration of Short Option on 9/19/2020
SPY 200.70
Buy Sep-14 203 -$2.30
Sell Nov-14 198 $2.60
Actual Profit After Adding Credit $0.68
FB Facebook
Date 9/3/2020
Underlying Price 75.74
Put Strike Price
Buy Oct-14 75 -$2.63
Sell Sep-14 80 $4.20
Profit/Loss Analysis at Expiration of Short Option
Debit -$1.57 + Remaining Time Value of Long Option
Maximum Loss -$5.00 + Remaining Time Value of Long Option
Actual Profit/Loss at Expiration of Short Option on 9/19/2020
FB 77.91
Buy Sep-14 80 -$2.09
Sell Oct-14 75 $0.18
Actual Loss After Subtracting Debit -$3.48

Conclusion

Of course, there are many more possibilities than can be listed in this article. For instance, a diagonal back spread can also be established by buying more calls than what is sold. This reduces the risk of buying calls because the cost is offset by the sold short call. If the price of the underlying advances, then the excess long calls will earn a greater profit.

Keep in mind that all spreads, including diagonal spreads, that use American-style options have assignment risk. If a trader is assigned to fulfill the option contract, then there must be sufficient equity or margin in the account to cover the assignment, especially if the trader wants to hold the long option beyond the date of assignment.

Diagonal Spread

What Is a Diagonal Spread?

A diagonal spread is an options strategy established by simultaneously entering into a long and short position in two options of the same type (two call options or two put options) but with different strike prices and different expiration dates. Typically these structures are on a 1 x 1 ratio.

This strategy can lean bullish or bearish, depending on the structure of the options.

How a Diagonal Spread Works

This strategy is called a diagonal spread because it combines a horizontal spread, also called a time spread or calendar spread, which represents the difference in expiration dates, with a vertical spread, or price spread, which represents the difference in strike prices.

The names horizontal, vertical and diagonal spreads refer to the positions of each option on an options grid. Options are listed in a matrix of strike prices and expiration dates. Therefore, options used in vertical spread strategies are all listed in the same vertical column with the same expiration dates. Options in a horizontal spread strategy use the same strike prices, but are of different expiration dates. The options are therefore arranged horizontally on a calendar.

Options used in diagonal spreads have differing strike prices and expiration days, so the options are arranged diagonally on the quote grid.

Types of Diagonal Spreads

Because there are two factors for each option that are different, namely strike price and expiration date, there are many different types of diagonal spreads. They can be bullish or bearish, long or short and utilize puts or calls.

Most diagonal spreads refer to long spreads and the only requirement is that the holder buys the option with the longer expiration date and sells the option with the shorter expiration date. This is true for call strategies and put strategies alike.

Of course, the converse is also required. Short spreads require that the holder buys the shorter expiration and sells the longer expiration.

What decides whether either a long or short strategy is bullish or bearish is the combination of strike prices. The table below outlines the possibilities:

Diagonal Spreads Diagonal Spreads Expiration Dates Expiration Dates Strike Price Strike Price Underlying Assumption
Calls Long Sell Near Buy Far Buy Lower Sell Higher Bullish
Short Buy Near Sell Far Sell Lower Buy Higher Bearish
Puts Long Sell Near Buy Far Sell Lower Buy Higher Bearish
Short Buy Near Sell Far Buy Lower Sell Higher Bullish

Example of a Diagonal Spread

For example, in a bullish long call diagonal spread, buy the option with the longer expiration date and with a lower strike price and sell the option with the near expiration date and the higher strike price. An example would be to purchase one December $20 call option and the simultaneous sale of one April $25 call.

Logistics

Typically long vertical and long calendar spread results in a debit to the account. With diagonal spreads, the combinations of strikes and expirations will vary, but a long diagonal spread is generally put on for a debit and a short diagonal spread is setup as a credit.

Also, the simplest way to use a diagonal spread is to close the trade when the shorter option expires. However, many traders “roll” the strategy, most often by replacing the expired option with an option with the same strike price but with the expiration of the longer option (or earlier).

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