Diagonal Call Time Spread

Diagonal Call Time Spread Risk Graph
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Diagonal Call Time Spread - Introduction



The Diagonal Call Time Spread, also known as the Call Diagonal Time Spread, is a neutral options strategy that profits when the underlying stock remains stagnant or within a very tight price range and reaches its maximum profit potential when the stock goes moderately higher. Like all time spreads, the Diagonal Call Time Spread profits through the difference in time decay between options with longer expiration and options with shorter expiration. With a long expiration call option in place, or a LEAPS call option, one Diagonal Call Time Spread can be rolled forward. Another advantage of the Diagonal Call Time Spread is that it is a debit spread. Most neutral options strategies are credit spreads which requires margin to put on.

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Types of Call Time Spreads


The Diagonal Call Time Spread is one of two types of time spreads that uses only call options. The other one being the Horizontal Call Time Spread which produces a higher profit if the underlying stock remained totally stagnant. Therefore, if the underlying stock is expected to remain totally stagnant, the Horizontal Call Time Spread would better maximize your profitability than the Diagonal Call Time Spread.



Differences Between Diagonal Call Time Spread and Horizontal Call Time Spread


The Diagonal Call Time Spread has a higher maximum profit potential and a wider profitable range than a Horizontal Call Time Spread. This is due to the fact that the Diagonal Call Time Spread allows the underlying stock some room to move upwards which increases the value of the long term call options. Even though the Diagonal Call Time Spread has a higher maximum profit potential, it actually returns a lower profit than the Horizontal Call Time Spread if the underlying stock remains totally stagnant. This is because the stock needs to move upwards to the strike price of the short call options in order for the Diagonal Call Time Spread to produce its maximum profit. The Diagonal Call Time Spread also requires more money to put on as out of the money call options of lesser value than at the money options are written. Such is the kind of trade off in options trading. Because out of the money call options are written, Diagonal Call Time Spreads also have an assymetric risk graph which produces its maximum loss (the net debit) only when the stock falls strongly. If the stock rallies strongly, the Diagonal Call Time Spread would also produce a much lesser loss than the Horizontal Call Time Spread. As such, you would use a Diagonal Call Time Spread options trading strategy when a stock is expected to remain within a tight price range and might move moderately higher.



When To Use Diagonal Call Time Spread?


Diagonal Call Time Spreads could be used when you wish to profit from a stock that is expected to stay stagnant or move up slightly for the short term while keeping a long term call option position in place in case of future breakouts.




How To Use Diagonal Call Time Spread?


In a Diagonal Call Time Spread, Out of The Money (OTM) near term call options are written and then at the money (ATM) long term calls are bought.

Buy Long Term ATM Call + Sell Short Term OTM Call


Diagonal Call Time Spread Example
Assuming QQQQ trading at $45 now. Buy To Open 10 contracts of QQQQ Jan 2008 $45 Call options at $4.70.
Sell To Open 10 contracts of QQQQ Jan 2007 $46 Call at $0.50.
Net Debit = $4.70 - $0.50 = $4.20

Compare the net debit with the net debit paid for the Horizontal Call Time Spread using at the money options, you would see that the Diagonal Call Time Spread requires more money to put on on the same base strike price.



Profit Potential of Diagonal Call Time Spread :


The Diagonal Diagonal Call Time Spread makes its maximum profit potential when the stock closes at the strike price of the short term call options upon expiration of the short term call options.


Profit Calculation of Diagonal Call Time Spread:


The value of a Diagonal Call Time Spread during expiration of the short call options can only be arrived at using an options pricing model such as the Black-Scholes Model because the expiration value of the long term call options can only be arrived at using such a model.

Diagonal Call Time Spread Example
Assuming QQQQ closes at $46 upon expiration of the short term call options.
The 10 contracts of QQQQ Jan 2008 $45 Call options is now trading at $5.00.
The 10 contracts of QQQQ Jan 2007 $46 Call expired worthless.

Net Profit = $0.50 (total premium gained from the Jan 2007 $46 Call) + $0.30 (profit on long term call options)
= $0.80 x 1000 = $800.

From the above example, you can see the huge difference in maximum profit attainable by the Horizontal Call Time Spread and the Diagonal Call Time Spread.



Loss Calculation of Diagonal Call Time Spread:


The Diagonal Call Time Spread makes it maximum possible loss, which is the net debit paid, when the underlying stock falls drastically. In this case, the premium earned from writing the short term call options serve as a hedge against the drop in value of the long term call options, up to the value of the short term call options written.

Conversely, when the underlying stock rallies, the out of the money call options gain in value only slightly faster than the long term at the money call options, resulting in a much lower loss than if the underlying stock falls. This is unlike a horizontal call time spread where maximum loss is the same when the stock rallies or falls.



Risk / Reward of Diagonal Call Time Spread:



Upside Maximum Profit: Limited

Maximum Loss: Limited
(limited to net debit paid when stock falls strongly)



Diagonal Call Time Spread Breakeven Calculation:


The breakeven point of a Diagonal Call Time Spread is the point below or above which the position will start to lose money if the underlying stock rises or falls strongly and can only be calculated using the Black-Scholes model.



Advantages Of Diagonal Call Time Spread:



  • Higher profit can be attained when the stock moved moderately higher.

  • Can be rolled forward for as many months as the expiration month of the long term call options.

  • Losses are limited to the net debit.

  • No Margin Needed.



    Disadvantages Of Diagonal Call Time Spread:



  • Profits are limited.

  • Maximum profit lower than Horizontal Call Time Spread if stock remains stagnant.



    Alternate Actions for Diagonal Call Time Spreads Before Expiration :



    1. If you wish to profit from a rally in the underlying asset, you could buy back the short call options before it expires and allow the LEAPS Call Options to continue its profit run.



    Questions About Diagonal Time Spreads

  • "How To Erase Margin Requirement In a Time Spread?"



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