Buy one long-term call at a lower strike price and sell one shorter-term call at a higher strike price to create a diagonal spread with calls. The trade resembles a hybrid of a covered call and a long calendar spread with calls. The concept is that a trader wants to sell upside calls while also ensuring their safety in the event that the stock rises.
The trader can keep selling upside calls in opposition to their long further out call if the execution is successful. Therefore, after one short-term call expires, the trader can sell another short-term call that is scheduled to expire in the month after. This can be done up until the month in which the long call is scheduled to expire.
Profit/Loss
The total premiums received from selling short-term upside calls, less the initial premium paid to execute the trade, plus the stock price less the strike price on the final month, are added up to determine the maximum profit.
When the stock trades below the long-term call strike price, the diagonal call spread’s maximum loss is limited to the cost of the trade.
Breakeven
It is impossible to determine a breakeven point for this dynamic trade because there are so many different scenarios and potential future trades.
Example
A trader could buy the June 100 call for Rs4 and then sell the April 105 call for Rs1.25, resulting in an initial cost of Rs2.75, if XYZ is trading at Rs100 and it is anticipated to trade higher over the next four months.
A trader could buy the June 100 call for Rs4 and then sell the April 105 call for Rs1.25, resulting in an initial cost of Rs2.75, if XYZ is trading at Rs100 and it is anticipated to trade higher over the next four months.
The April call is removed from the account if the stock trades up to Rs103 by April expiration, and the trader has earned a profit on the long call. Then, for Rs1.75, they could sell a May 105 strike call. The trader keeps the Rs1.75 and gains Rs5 of intrinsic value in the long-term call if the stock trades up to Rs105 by May expiration. Then, for Rs1.25, they could sell a June 110 call. By June expiration, if the stock is trading at or above Rs108 the June call will also expire worthless. In this case, the trader would have opened the trade by paying a premium of Rs2.75 and pocketing premiums of Rs1.75 and Rs1.25 along the way.
Additionally, the stock would have an intrinsic value of Rs8. The total profit would be (Rs8+Rs1.75+Rs1.25-Rs2.75), or Rs8.25.
But if the stock dropped to Rs90 after the initial trade, both options would lose too much value, making it impossible to continue with the strategy. Both options would expire worthless and the trader would lose their Rs2.75 investment if the stock never rose in price.
Conclusion
This is a more sophisticated strategy that aims to profit from higher short-term volatility. The best scenario is for the stock to increase gradually over time. That can be challenging, of course, if the strategy’s primary goal is to capture volatility.
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