Diagonal Spreads: Adding a Directional Bias to Calendar Spreads

Beyond the Traditional Calendar Spread

While the traditional calendar spread is a neutral strategy, designed to profit from time decay and changes in volatility, there are times when a trader may want to introduce a directional bias to the position. This is where the diagonal spread comes in.

A diagonal spread is a variation of the calendar spread where the options have different strike prices in addition to different expiration dates. This seemingly small change has a significant impact on the risk/reward profile of the trade, allowing the trader to express a bullish, bearish, or neutral-with-a-bias view on the underlying asset.

Types of Diagonal Spreads

There are four basic types of diagonal spreads:

• Bull Call Diagonal: Buy a longer-dated, lower-strike call and sell a shorter-dated, higher-strike call.
• Bear Call Diagonal: Buy a longer-dated, higher-strike call and sell a shorter-dated, lower-strike call.
• Bull Put Diagonal: Buy a longer-dated, lower-strike put and sell a shorter-dated, higher-strike put.
• Bear Put Diagonal: Buy a longer-dated, higher-strike put and sell a shorter-dated, lower-strike put.

The Bull Call Diagonal: A Closer Look

The bull call diagonal is one of the most popular diagonal spread strategies. It is a bullishly biased trade that can be established for a net debit or a net credit, depending on the strike prices and expiration dates chosen.

The strategy profits if the underlying asset price rises, but it also benefits from time decay if the price remains stable. This dual source of potential profit makes it a versatile strategy for a variety of market conditions.

A Practical Example: Bull Call Diagonal on AAPL

Let's consider a bull call diagonal spread on Apple Inc. (AAPL), assuming the stock is trading at $170.

• Sell: 1 AAPL 175 Call with 30 DTE for a premium of $2.00
• Buy: 1 AAPL 165 Call with 60 DTE for a premium of $8.00

Net Debit: $6.00 per share, or $600 per contract.

Maximum Loss: The maximum loss is limited to the net debit paid, which is $600. This occurs if AAPL falls below the long strike price ($165) at the expiration of the long-term option.

Maximum Profit: The maximum profit is realized if AAPL is trading at the strike price of the short call ($175) at the expiration of the short-term option. In this scenario, the short call expires worthless, and the long call has appreciated in value due to the upward move in the stock price. The exact profit will depend on the implied volatility at that time.

Comparing Diagonal Spreads to Other Strategies

Diagonal spreads offer a unique combination of features that differentiate them from other options strategies:

• vs. Calendar Spreads: Diagonals introduce a directional bias, while traditional calendars are neutral.
• vs. Vertical Spreads: Diagonals have a time component, allowing them to profit from theta decay, which is not a primary factor in vertical spreads.
• vs. Covered Calls: A bull call diagonal can be thought of as a "poor man's covered call." It offers a similar risk/reward profile to a covered call but requires significantly less capital to establish.

Managing Diagonal Spreads

Like calendar spreads, diagonal spreads require active management.

• Adjusting for Directional Moves: If the underlying asset moves significantly against the position, the spread may need to be adjusted or closed to manage risk.
• Rolling the Short Leg: As the short-term option approaches expiration, it can be rolled to a later date and/or a different strike price to continue generating income and adjust the directional bias of the position.
• Managing Early Assignment: If the short call becomes deep in-the-money, there is a risk of early assignment. This is particularly true if there is a dividend payment approaching.

Diagonal spreads are a effective tool for experienced options traders. By adding a directional component to the traditional calendar spread, they offer a flexible and capital-efficient way to express a variety of market views.