Volatility Paradox

Overview

The Diagonal Spread is a sophisticated strategy that lives at the intersection of a Vertical Spread and a Calendar Spread.

You are buying a long-term option at one strike and selling a short-term option at a different strike. This allows you to benefit from time decay (like a Calendar) while also having a directional bias (like a Vertical).

[!TIP] A common way to use this is the "Poor Man's Covered Call." You buy a deep-in-the-money long-dated call to act as a substitute for stock, and then sell short-term out-of-the-money calls against it.

The Setup

A Long Diagonal Call Spread consists of:

Short Leg: Sell 1 Call at Strike $K_1$ , expiring soon.
Long Leg: Buy 1 Call at Strike $K_2$ , expiring later.

Mechanics: The Two-Way Win

Direction: If $K_2$ (the one you bought) is lower than $K_1$ (the one you sold), the trade has a Bullish bias.
Time: Like a calendar, the near-term option you sold decays faster than the long-term one you bought.

Payoff and Break-even

Max Profit

Occurs if the stock is exactly at the short strike ( $K_1$ ) when the short option expires. At this point, the short option is worthless, and your long option has maximum "extrinsic value" remaining.

Max Loss

The net debit you paid. However, if the stock crashes, your long option still has time value, so you might not lose the full amount immediately.

The "Shaped" Greeks

Diagonals allow you to "shape" your risk profile more precisely than almost any other trade.

1. Delta: Tunable Bias

By choosing how far apart your strikes are, you can control your Delta. A deeper-in-the-money long call will give you more "stock-like" exposure.

2. Vega: Structurally Long

Because your long leg is further out in time, it has more Vega. You generally want Volatility to rise or stay stable. An IV crush is the biggest enemy of a diagonal spread.

3. Gamma: The Short-Term Risk

Near expiration, your short leg develops high Gamma. If the stock explodes past $K_1$ , your gains on the long leg might not keep up with the losses on the short leg.

When to Use?

Slow Drifting Markets: You think the stock will go up, but you think it will take its time getting there.
Stock Substitute: You want the profile of a Covered Call but don't want to tie up the capital needed to buy 100 shares of stock.

Checklist for Entry

Is my long strike deep enough in the money to provide a high Delta?
Is the short strike far enough away that I won't be assigned immediately?
Have I checked the Earnings calendar? (You don't want an IV crush on your long-dated leg).

The 'Poor Man's' Delta MathRead more

To make a Diagonal feel like a Covered Call, traders often target a "Net Delta" of roughly 0.60 to 0.80.

\Delta_{\text{net}} = \Delta_{\text{long}} - \Delta_{\text{short}}

If your long call has a 0.90 delta and your short call has a 0.20 delta, you are effectively "controlling" 70 shares of stock for a fraction of the price.

Diagonal Spread