Diagonal Spread Strategy: Complete Guide with Examples

Diagonal spreads combine elements of vertical spreads and calendar spreads into a versatile strategy that can generate income while maintaining directional exposure. By using options with different strike prices and different expiration dates, you create a position that profits from time decay while benefiting from stock movement. This comprehensive guide explains everything you need to know about diagonal spreads.

What is a Diagonal Spread?

A diagonal spread involves buying a longer-dated option at one strike price and selling a shorter-dated option at a different strike price. The term "diagonal" comes from how the position would appear on an options chain - moving diagonally across both strike prices (vertical) and expiration dates (horizontal).

Types of Diagonal Spreads

Call Diagonal Spread (Bullish)

A call diagonal is bullish and profits from moderate upward movement.

• Buy a longer-dated call at a lower strike (in-the-money or at-the-money)
• Sell a shorter-dated call at a higher strike (out-of-the-money)
• Similar to a covered call but using a LEAPS instead of stock

Put Diagonal Spread (Bearish)

A put diagonal is bearish and profits from moderate downward movement.

• Buy a longer-dated put at a higher strike (in-the-money or at-the-money)
• Sell a shorter-dated put at a lower strike (out-of-the-money)
• Profits from stock decline and time decay

How Diagonal Spreads Profit

Time Decay (Theta)

The short-dated option decays faster than the long-dated option. This differential theta is your friend:

• Short option loses value daily at an accelerating rate
• Long option loses value more slowly due to longer time horizon
• The gap widens as the short option approaches expiration

Directional Movement

The different strikes give you directional exposure:

• Call diagonal profits if the stock rises toward the short strike
• Put diagonal profits if the stock falls toward the short strike
• Ideal outcome: stock moves slowly toward your short strike

Volatility Impact

Diagonal spreads are affected by implied volatility changes:

• Long option has more vega exposure (longer-dated)
• Rising IV generally helps the position
• Falling IV can hurt even if direction is correct

The Ideal Scenario

For a call diagonal spread, the ideal outcome is:

• Stock rises slowly toward your short strike
• Short option expires worthless or near worthless
• Long option retains most of its value
• You sell another short-dated call for more income
• Repeat until the long option expires

Profit and Loss Analysis

Maximum Profit

Maximum profit is difficult to calculate exactly because the long option still has time value when the short expires. Generally:

• Best case: Short option expires worthless while long option gains value
• The stock sits at or just below the short strike at expiration
• After short expires, sell another for more income

Maximum Loss

Maximum loss is the net debit paid if both options expire worthless:

• Call diagonal: Stock crashes and both calls become worthless
• Put diagonal: Stock rallies and both puts become worthless
• Maximum loss = Initial debit paid

Breakeven

Breakeven is complex due to different expirations. Generally:

• You need the long option to be worth more than your net debit
• Time decay from selling multiple short options reduces cost basis
• Each sold option lowers your breakeven point

Managing Diagonal Spreads

When the Short Option Expires Worthless

This is the ideal outcome. Your next steps:

• Assess the stock price relative to your long strike
• Sell another short-dated option at an appropriate strike
• Collect more premium to further reduce cost basis
• Repeat until the long option nears expiration

When the Stock Moves Through the Short Strike

If the stock moves past your short strike (in-the-money):

• Roll the short option: Buy back the short, sell a higher strike or later date
• Close the entire position: Take profits if satisfied with returns
• Let it get called away: Close both legs for maximum spread value

When the Stock Moves Against You

If the stock moves away from your short strike:

• Call diagonal, stock drops: Short option becomes worthless (good), but long option loses value (bad)
• Roll the short down: Sell a lower strike to collect more premium
• Close for a loss: If outlook has changed, exit the position
• Hold and wait: If you still expect recovery, hold the long option

Diagonal Spread vs Calendar Spread

Choosing Strike Prices

Long Option Strike

• In-the-money: Higher delta, behaves more like stock, more expensive
• At-the-money: Moderate delta, balanced risk/reward
• Out-of-the-money: Lower cost but requires bigger move to profit

Short Option Strike

• Typically out-of-the-money for income generation
• Choose based on resistance levels or price targets
• Higher strikes = less premium but more room for stock to move

Choosing Expirations

Long Option

• LEAPS (9-24 months): Best for multiple short option sales
• 6-9 months: Moderate time horizon, still multiple sales possible
• 3-6 months: Shorter campaign, fewer opportunities to sell

Short Option

• 30-45 days: Optimal theta decay rate
• Weekly: More frequent management, higher annualized returns
• 60+ days: Less management but slower decay

The Poor Man's Covered Call Connection

A diagonal spread using a deep in-the-money LEAPS call is known as a Poor Man's Covered Call (PMCC). It replicates a covered call position with less capital:

• Buy deep ITM LEAPS (delta 0.70-0.85)
• Sell short-dated OTM calls
• Requires 60-80% less capital than buying shares
• Functions like owning stock but with limited risk

Tips for Success with Diagonal Spreads

• Buy quality long options: Deep ITM or ATM with high delta
• Sell premium consistently: Each month, sell another short-dated option
• Track your cost basis: Keep records of all premium collected
• Roll proactively: Do not wait until the short is deep ITM
• Watch implied volatility: Rising IV helps, falling IV hurts
• Have an exit plan: Know when to close the entire position

Common Mistakes to Avoid

• Buying cheap OTM longs: Low delta options do not replicate stock movement
• Short expiration on long option: Not enough time to sell multiple shorts
• Ignoring assignment risk: Short options can be assigned early
• Over-managing: Rolling too frequently increases transaction costs
• Wrong directional bias: Call diagonal loses if stock crashes

Summary

Diagonal spreads combine the benefits of vertical spreads and calendar spreads into a flexible strategy for generating income with directional bias. By buying a longer-dated option and selling shorter-dated options against it, you create a position that profits from time decay while maintaining exposure to stock movement. The key to success is selecting quality long options with sufficient time, consistently selling short-dated premium, and managing the position proactively. Whether you call it a diagonal spread or a Poor Man's Covered Call, this strategy is a capital-efficient way to generate consistent income from the options market.

Want to take this strategy further? Learn about double diagonal spreads or explore calendar spreads for income.