DIAGONAL SPREAD
Overview
A calendar spread with different strikes. Buy a longer-dated option at one strike and sell a shorter-dated option at a different strike. Combines directional bias with time decay income. The most flexible spread structure for traders who want premium income alongside a directional lean.
What it does
A diagonal spread combines calendar and vertical spread elements. You buy a longer-dated option at one strike and sell a shorter-dated option at a different (typically higher for calls) strike. The near-term sold option generates income that reduces your cost basis while the longer-dated long option captures your directional thesis. It's like a covered call but using options instead of stock.
Structure
buy 1 longer-term option (one strike) + sell 1 near-term option (different strike)
Setup
- 1.Buy 1 longer-term option at your directional strike.
- 2.Sell 1 near-term option at a different strike (typically OTM). Different strikes and expirations.
Max profit
Limited — depends on strike selection, time decay captured, and the directional move.
Max loss
Net Debit Paid (worst case if both options expire worthless).
Breakeven
Varies based on strike widths, time remaining, and implied volatility at the front-month expiration.
When to use
When you have a directional bias but want to fund part of the trade by selling near-term premium against it.
When to avoid
When IV is expected to collapse sharply or the stock may move strongly against your directional assumption.
Example trade
Stock: AAPL at $150 (mildly bullish) Buy 1 AAPL $150 Call (90-day LEAPS) at $10.00 Sell 1 AAPL $155 Call (30-day) at $2.50 Net Debit: $7.50 ($750) If AAPL stays at $152: 30-day call expires worthless; long call now worth ~$8.00 Profit = ($8.00 - $7.50) × 100 = $50 (small profit) Repeat monthly: sell another short call next month
Common mistakes
- ×Choosing the short strike too close to the long strike — limits potential upside gain from the long option.
- ×Buying very expensive LEAPS for the long leg — high entry cost makes the strategy less efficient.
- ×Forgetting to roll the short leg when it expires — otherwise you're left with just a long option.
- ×Selling the short option too far ITM — creates assignment risk and caps gains prematurely.
- ×Over-complicating by using very different strike widths — hard to model and manage.
FAQ
Is a diagonal spread the same as a covered call?
Economically similar — both sell an OTM call against a long position. A diagonal uses a long option instead of stock, making it cheaper but adding expiration/IV risk.
How do I 'roll' a diagonal spread?
When the short option expires, sell another near-term option against your remaining long option. This continues generating income while your long option maintains its value.