A diagonal spread combines elements of both vertical spreads and calendar spreads. It uses options at different strike prices AND different expiration dates. This flexibility makes diagonal spreads a favorite among income-focused traders who want directional exposure with time decay benefits.
What is a Diagonal Spread?
A diagonal spread involves buying one option and selling another option of the same type (both calls or both puts) with different strike prices and different expiration dates. The "diagonal" name comes from how the position looks on an options chain: it moves diagonally across both price and time.
Simple version: Think of a diagonal spread as a covered call or cash-secured put, but instead of owning stock, you own a longer-dated option. This reduces your capital requirement while maintaining similar income potential.
Types of Diagonal Spreads
Call Diagonal Spread (Poor Man's Covered Call)
The most popular diagonal spread. It mimics a covered call position at a fraction of the cost.
- Buy a long-dated, in-the-money call (LEAPS)
- Sell a short-dated, out-of-the-money call
Call Diagonal Example
Stock ABC is trading at $100. Instead of buying 100 shares for $10,000:
- Buy 1 January 2027 $85 call for $20.00 ($2,000)
- Sell 1 February 2026 $105 call for $2.00 ($200 credit)
Net debit: $18.00 ($1,800) vs $10,000 for shares
Strategy: Collect premium from the short call monthly while the long call provides delta exposure
If ABC stays below $105: Keep the $200 premium, sell another call next month
If ABC goes above $105: May need to roll the short call or close the position for profit
Put Diagonal Spread (Poor Man's Covered Put)
The bearish counterpart. Used when you have a moderately bearish outlook.
- Buy a long-dated, in-the-money put
- Sell a short-dated, out-of-the-money put
Why Use Diagonal Spreads?
- Capital efficiency: Control 100 shares worth of delta for a fraction of the stock cost
- Income generation: Repeatedly sell short-term options against your long option
- Defined risk: Maximum loss is limited to your net debit paid
- Flexibility: Adjust the short strike based on your outlook
- Time decay advantage: Short option decays faster than long option
Diagonal Spread Mechanics
The profitability of a diagonal spread depends on several factors:
- Stock price movement: Ideally moves toward your short strike by short expiration
- Time decay differential: Short option loses value faster than long option
- Implied volatility: Rising IV benefits the long option more than it hurts the short
- Strike selection: Distance between strikes affects risk/reward profile
Key insight: The ideal scenario is for the stock to be exactly at your short strike at the short option's expiration. This lets you keep maximum premium while maintaining your long option's value.
Managing Diagonal Spreads
When the Short Option Expires
- Stock below short strike: Short option expires worthless. Sell a new short-dated option.
- Stock at short strike: Perfect outcome. Keep full premium and sell another option.
- Stock above short strike: Either roll the short option up and out, or close the entire position.
Rolling the Short Option
Rolling means closing your current short option and opening a new one:
- Roll out: Same strike, later expiration (if stock has not moved much)
- Roll up and out: Higher strike, later expiration (if stock has risen)
- Roll down: Lower strike (if stock has dropped and you want to collect more premium)
Risk Analysis
Maximum Loss
Your maximum loss is the net debit paid to enter the position. This occurs if the underlying drops significantly and both options expire worthless.
Maximum Profit
Theoretically unlimited on call diagonals (as stock rises), but practically capped by the short call. Maximum profit occurs when the stock is at the short strike at short expiration.
Break-Even Point
Diagonal spreads have complex break-even calculations because of the different expirations. Generally, you need the stock to move favorably or stay stable enough to collect multiple rounds of premium.
Risk Scenario Analysis
Using our earlier example (bought $85 call for $20, sold $105 call for $2):
- Best case: Stock at $105 at short expiration - keep $200, long call worth approximately $21
- Good case: Stock at $100 - keep $200, sell another call next month
- Bad case: Stock drops to $80 - short expires worthless ($200 profit) but long call loses significant value
- Worst case: Stock crashes to $60 - long call loses most value, total loss approaches $1,800
Diagonal Spread vs Calendar Spread
- Calendar spread: Same strike, different expirations. Neutral strategy.
- Diagonal spread: Different strikes, different expirations. Directional bias.
- Capital requirement: Diagonals typically cost more (buying ITM long option)
- Flexibility: Diagonals offer more adjustment options
Diagonal Spread vs Covered Call
- Capital required: Diagonal uses roughly 10-20% of covered call capital
- Risk: Both have defined maximum loss (stock to zero vs debit paid)
- Dividends: Covered call receives dividends; diagonal does not
- Leverage: Diagonal provides more leverage (good and bad)
- Time limit: Diagonal's long option eventually expires; stock does not
Tips for Trading Diagonal Spreads
- Buy deep ITM long options: Higher delta means better stock price tracking
- Choose long expirations: At least 6 months to a year for the long leg
- Sell 30-45 DTE short options: Optimal time decay zone
- Keep short strike OTM: Gives room for the stock to move without assignment risk
- Monitor your break-even: Know when you have collected enough premium to cover your cost
- Have an exit plan: Decide in advance when you will close the entire position
Track Your Diagonal Spreads
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Summary
Diagonal spreads combine the income potential of covered calls with the capital efficiency of options. By buying a long-dated option and repeatedly selling short-dated options against it, you can generate income while maintaining directional exposure. The strategy works best in slowly trending or range-bound markets where you can collect multiple rounds of premium before the long option expires.
Learn about related strategies: calendar spreads and covered calls.