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

This spread is typically created using a ratio of 1-2-1 (1 ITM option, 2 ATM options, 1 OTM option).

– Buy Call/Put (above short strike)

– Sell 2 Calls/Puts

– Buy Call/Put (below short strike)

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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.

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 )

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 )

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.

The exact maximum profit potential is the distance between the short strike and long strike, less the debit paid.

( strike width- debit paid )

The break-even cannot be calculated with the following formula:

– Upside: Higher Long Option Strike – Debit Paid

– Downside: Lower Long Option Strike + 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.