A diagonal spread is a calendar spread with a directional lean. You still sell a short-dated option against a longer-dated one, but at different strikes. The most common version, a bullish call diagonal, works a lot like a covered call: the long-dated call stands in for the shares, and you sell short-term calls against it.
How it’s built
For a bullish call diagonal:
- Buy a longer-dated call at a lower strike, at or in the money. This is your core position.
- Sell a shorter-dated call at a higher strike, out of the money. This brings in premium.
You pay a net debit. Each time the short call expires, you can sell another one against the same long call, which is why some traders call this a “poor man’s covered call”.
Max profit, max loss and break-even
| Bullish call diagonal | |
|---|---|
| Max profit | Roughly reached if the stock is at the short strike when the short call expires. It depends on the long call’s remaining time value. |
| Max loss | The net debit, if the stock falls far enough that the long call is close to worthless |
| Break-even | Depends on implied volatility; check it with a calculator or your broker’s risk graph |
Worked example
Apple ($AAPL) is at $150 and you’re mildly bullish over the next few months. You buy the three-month $150 call for $8 and sell the one-month $160 call for $2. Net cost: $6 a share, or $600. (Premiums here are for illustration.)
- AAPL drifts up to $160 by the first expiration: the short call expires worthless, and the long call is worth at least $10 with two months still left. That’s the best outcome: a gain, and you can sell another call.
- AAPL stays at $150: the short call expires worthless and you keep the $2. The long call has lost some time value, but you can sell another one-month call against it to keep collecting premium.
- AAPL jumps to $175: the short call is $15 in the money, but your long call is $25 in the money and still has time value, so the spread stays profitable. The upside is capped, but it isn’t a loss.
- AAPL drops to $135: the short call expires worthless, but the long call loses much of its value. The most you can lose is the $600 debit.
When it makes sense
- You’re mildly bullish (or, with puts, mildly bearish) over a few months.
- You’d like covered-call-style income without buying 100 shares.
- You’re willing to manage the trade every time the short option expires.
What to watch out for
- A sharp drop. The long call loses value fast, and the premiums you’ve collected may not cover it.
- Too fast a rally. Above the short strike, your profit stops growing, and you may need to roll the short call up and out.
- Getting the strikes backwards. The long option should be the one closer to the money. Selling the lower strike and buying the higher one exposes you to bigger losses on a rally.
Tips
- Buy enough time on the long leg. Three months or more gives you room to sell several short calls.
- Sell the short call at a price you’d be happy to see. If the stock gets there, the trade is working.
- Roll the short leg before it’s deep in the money, rather than waiting until expiration day.
For the covered-call version with real shares, see the covered call guide.