Short Diagonal Calendar Call Spread

How Does Short Diagonal Calendar Call Spread Work in Options Trading?

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Short Diagonal Calendar Call Spread - Introduction

The Short Diagonal Calendar Call Spread, also known as the Short Calendar Diagonal Call Spread, is a volatile options strategy that profits when the underlying stock breaks out either to upside or downside.

It produces its maximum profit potential when the stock breaks out to downside which makes it more preferrable to its close cousin, the Short Horizontal Calendar Call Spread, if the underlying stock has a greater chance of breaking out to downside. The Short Diagonal Calendar Call Spread also has a higher maximum profit potential than maximum loss potential, putting the risk/reward balance in your favor. As a credit spread, however, margin would be required.

This tutorial shall cover all aspects of the Short Diagonal Calendar Call Spread including calculations, advantages and disadvantages.

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Types of Calendar Call Spreads

The Short Diagonal Calendar Call Spread is one of two types of short calendar spreads utilizing only call options. The other one is the Short Horizontal Calendar Call Spread which produces an equal maximum profit no matter which direction the underlying stock breaks out.

Differences Between Short Diagonal Calendar Call Spread and Short Horizontal Calendar Call Spread

The main difference between the Short Diagonal Calendar Call Spread and the Short Horizontal Calendar Call Spread is that instead of buying short term at the money call options, the Short Diagonal Calendar Call Spread buys out of the money call options. Due to the fact that cheaper out of the money call options are bought, the maximum profit potential of the Short Diagonal Calendar Call Spread is higher than the Short Horizontal Calendar Call Spread as lesser premium is wasted on the short term options. However, that also created an assymetric risk profile with maximum profit achieved only when the underlying stock breaks out to downside. So, if stock is expected to breakout with a higher probability to downside, profit would be better maximised using the Short Diagonal Calendar Call Spread instead of the Short Horizontal Calendar Call Spread.

When To Use Short Diagonal Calendar Call Spread?

Short Diagonal Calendar Call Spreads are used to profit from stocks that are expected to break out with a higher probability of breaking out to downside.

How To Use Short Diagonal Calendar Call Spread?

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

Sell Long Term ATM Call + Buy Short Term OTM Call

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

Profit Potential of Short Diagonal Calendar Call Spread :

The Diagonal Short Diagonal Calendar Call Spread makes its maximum profit potential when the stock breaks out to downside to the extent where the extrinsic value of the long term call options are totally diminished.

Profit Calculation of Short Diagonal Calendar Call Spread:

Maximum profit = net credit

Maximum loss occurs when the underlying stock rises to the strike price of the out of the money long call options. When that happens, the long term short call options gain in intrinsic value without a corresponding move up on the short term long call options, incurring a greater loss than if the stock remained stagnant.

Short Diagonal Calendar Call Spread makes its maximum profit when the underlying stock breaks out downwards, removing the premium on all the options involved, resulting in the net credit being the maximum profit less any residual value on the long term options.

Short Diagonal Calendar Call Spread Example Assuming QQQQ closes at $40 upon expiration of the short term call options. The 10 contracts of QQQQ Jan 2008 $45 Call options are now trading at $0.01. The 10 contracts of QQQQ Jan 2007 $46 Call expired worthless. Net Profit = $4.20 - $0.01 = $4.19

The Short Diagonal Calendar Call Spread makes a smaller profit when the underlying stock breaks out upwards.

Short Diagonal Calendar Call Spread Example Assuming QQQQ closes at $50 upon expiration of the short term call options. The 10 contracts of QQQQ Jan 2008 $45 Call options are now trading at $5.01. The 10 contracts of QQQQ Jan 2007 $46 Call are now trading at $4.00. Position value = $5.01 - $4.00 = $1.01 Net Profit = $4.20 - $1.01 = $3.19

As you can see from the above calculations, the Short Diagonal Calendar Call Spread makes a higher profit than the Short Horizontal Calendar Call Spread when the underlying stock breaks out downwards but lower profit when the stock breaks out upwards.

Short Diagonal Calendar Call Spread Loss Example Assuming QQQQ closes at $46 upon expiration of the short term call options. The 10 contracts of QQQQ Jan 2008 $45 Call options are now trading at $5.20. The 10 contracts of QQQQ Jan 2007 $46 Call expired worthless. Net Loss = ($5.50 - $4.70) + $0.50 = $0.80 + $0.50 = $1.30

Risk / Reward of Short Diagonal Calendar Call Spread:

Maximum Profit: Limited

Maximum Loss: Limited

Short Diagonal Calendar Call Spread Breakeven Calculation:

The breakeven point of a Short Diagonal Calendar Call Spread is the point below and above which the position will start to make a profit and can only be calculated using the Black-Scholes model.

Advantages Of Short Diagonal Calendar Call Spread:

Higher profit can be attained when the stock breaks out to downside.

Losses are limited.

Disadvantages Of Short Diagonal Calendar Call Spread:

Profits are limited.

Maximum profit lower than Short Horizontal Call Time Spread if stock breaks out to upside.

Margin is needed.

Alternate Actions for Short Diagonal Calendar Call Spreads Before Expiration :

1. The moment the extrinsic value of the long and short term options are almost completely eroded due to a significant breakout, the position should be closed and profit taken. There is no need to hold til expiration because the engine that makes this options trading strategy work is the breakout, not time decay.

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