Diagonal Calendar Spreads

Learn how to use covered calls to reduce the price of buying a call or to hedge for the downside potential of your existing stocks.

Bullish Option | Diagonal Spread
Long Call Diagonal Spreads

Learn how to set up and profit from diagonal calendar spreads

A diagonal calendar spread is a combination of a calendar spread ( also known as a horizontal spread ) with a features of a vertical debit spread.

The strategy is similar in principle to a vertical debit spread where the underlying presumption is bullish but you want to fund your bull call by selling a call for premium.  By doing so, however, you will be capping your maximum profit but also limiting your risk 

Just as in a typical vertical debit spread that this strategy mimics, the diagonal calendar spread can be set up to be bullish using calls or bearish using puts.


The two most important reasons for setting up a covered call:

  • Reduce cost basis of buying a stock
  • Hedge an existing stock portfolio if you already own 100 shares of a stock.
  • Covered calls are profitable even if the stock down’t move
Covered calls are profitable unless the stock moves down below the break even price.  

A covered call reduces the cost basis of buying a stock by accepting a premium for selling a put above the stock price.  

If you were to sell the 105 put for a premium of 5 dollars.  The collected premium effectively lowers the cost basis of buying 100 shares of the stock at 100 dollars to buying the 100 dollars of shares at 95 dollars.  The break even price is now 95 dollars.

A bullish long call diagonal spread is set up by

  • Buy a distant month ITM call at a lower strike price
  • Sell a proximate month OTM call at a higher strike price
  • total debit paid should be no more than 75% of the strike width
  • The intrinsic value of the long strike should approximate the short strike.

You will want to set this trade up in a low volatility environment but with a bullish direction.  

A Long Call Diagonal Spread is constructed by purchasing a call far out in time, and selling a near term call on a further OTM strike to reduce cost basis. This trade is set up as a debit.

This option is typically closed when the short option expires. However, it is also common close the short option only to sell another short option for more premium either at the same strike price.

The setup of a diagonal spread is very important. If we have a bad setup, we can actually set ourselves up to lose money if the trade moves in our direction too fast. 

To ensure we have a good setup, we check the extrinsic value of our longer dated ITM option. Once we figure that value, we ensure that the near term option we sell is equal to or greater than that amount. 

The deeper ITM our long option is, the easier this setup is to obtain. We also ensure that the total debit paid is not more than 75% of the width of the strikes.


We never route diagonal spreads in volatility instruments. Each expiration acts as its own underlying, so our max loss is not defined.


The best stock movement scenario = ( believe it or not ) is for the stock to move in your favor and blow by above your short strike.  

The short strike would lose all of its value, but this is offset by the profit of the ITM in the money long options.  You would collect the maximum profit of the ( strike width + the premium received ) or 10+5 = 15.

You would only manage a covered call if the stock price completely goes against you and is below the break even price.  

Recall that a covered is profitable if either the stock price stays the same, moves between the strikes, or even it it moves above the short strike ( this is actually the best scenario )

If the stock moves in your favor and moves above the short strike, you will achieve maximum profit.  The maximum profit is calculated by the width of the strikes minus the debit you paid.

In this example, the width is 10 and the debit it 5.  So if the price goes above the short strike, you will collect a 5 dollar ( 10-5=5 ) profit.

If the stock moves against you and moves below the long strike, you will achieve maximum loss unless you adjust or manage your trade.  Maximum loss is simply the price of your debit premium.  In this case it is 5 dollars.

You will want to manage this trade by rolling the short strike down toward the long strike, while also narrowing the width of the spread.  

Rolling the short strike should gain you a credit ( lets say .30 cents ) while also narrowing the width of the spread.  This adjustment will lower the cost basis even if you continue to expect to lose money on the trade.

If the original debit was 5 dollars and you were able to get another 30 cents.  Then even if you still lose in the trade, your loss has decreased from 5 dollars to 4.7 dollars.

If the stock price now manages to rally ( before expiration ) and rally back above the short strike, you will now be profitable albeit a lesser profit than originally designed.  Remember that you managed this trade by bringing down the short strike and narrowing the strike width to 5 points wide.  Your profit is based now on a strike width of 5 minus the debit which is now 4.7.


If the stock price does not move at all, the short strike will expire worthless and you would keep the premium.

The long call is simply the change in the value of the stock, which in this case has not changed.

So the value of the option is the profit of the premium that was sold.  5 dollars.

Note that you can manage this trade by moving the short strike ( for a profit ) toward the stock price if you can get a credit and you remain bullish on the trade.  

Buying a naked call has negative theta.  The option loses value as the option approaches expiration.  The loss in value increases faster as time expires.

Selling a call has positive theta. The option benefits from time as it approaches expiration.  The option price will decrease allowing us to buy the option back at lower and lower prices as the option approaches expiration.

A strangle is an option strategy that is set up buy simultaneously BUYING an ATM ( at the money ) call AND an SELLING an ATM put.  

A conventional calendar spread is set up buy BUYING the same ATM call but SELLING the ATM call in a near month for credit.  

The exact maximum profit potential cannot be calculated due to the differing expiration cycles used. However, the profit potential can be estimated with the following formula:

( Strike width – net debit paid )

Note however, that the cost basis can be refreshed by closing out the short strike and selling it again for a credit.

The break-even cannot be calculated due to the differing expiration cycles used in the trade.  However, it can be approximated with the following formula:

( Long call strike price + net debit paid )

We generally look for 25-50% of max profit when closing diagonal spreads. Profit occurs when the long option moves further ITM and gains value, and/or if implied volatility increases.

We manage diagonal spreads when the stock price moves against our spread. In this case, we look to roll down the short option closer to the breakeven price, so that we can collect more premium and reduce our overall risk.

Option Basics


Same risk profile as a short put

Use to reduce the cost basis if you want to purchase a stock by selling a put against the purchase

You need to think of this in contrast to buying a stock outright



Setting Up a Covered Call

FYI- Would rather use strategies that sell premium rather than using debit spreads

Set up in low volatility environments

Straddle the stock price

Buy an ITM option and Sell an equidistant or slightly closer OTM option

Set up so that the break even is just around the stock price or ideally even just a little bit better

Debit spreads reduce the cost basis of the long option- caps the upside but reduces the max loss increasing your probability of success

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