DIAGONAL CALL SPREADS
CONTROLLING RISK AND MAXIMIZING RETURNS
Basic Framework - Diagonal Call Spreads:
A diagonal call credit spread strategy is an ideal way to balance risk and reward in options trading. This type of trade is a modified call credit spread. This strategy involves selling a call option and buying a call option while collecting a credit in the process (see call options explained). When selling the call option, premium is collected and simultaneously using some of that premium income to buy a further dated call option at a higher strike price. The net result will be a credit on the two-leg pair trade with defined risk since the purchase of the call option serves as protection. Diagonal spreads work best when IV Rank is very high.
By selling the call option, you agree to sell shares at the agreed upon price by the agreed upon expiration date. By buying the call option, you have the right to buy shares at the agreed upon price by the agreed upon expiration date. Thus risk is defined and capital requirements are minimal.
Risk is defined since you agree to sell shares at a specific price while also having the right to buy shares at a specific price. If a call option is sold at a strike price of $100 and another call option is purchased at a strike of $105 then the max loss is the strike width of $5.00 per share or $500 less the net premium received. Since the risk-defined approach has a max loss, the required capital is equivalent to the max loss. If the premium collected was $50 then the required capital would be $450 and at expiration of the contact an ROI of ~10% is obtained for a winning trade.
If the underlying security moves against you and challenges the $100 strike then potential losses come into play. Since you have the right to buy shares at a $105 strike, the stock could go to infinity and your losses would be capped at $450 since you’d be required to sell shares at $100 and then turn around and buy the shares for $105 per share. The required capital is equal to the maximum loss while the maximum gain is equal to the net option premium income received. Only $450 of capital would be required to execute the trade.
Opening a diagonal call spread is accomplished via selling a call and buying a call while taking in net premium income during the process. Capital requirement is equal to the strike width and risk is defined to maximize return on investment.
Potential Outcomes and Scenarios:
A normal call spread with the same expiration dates will expire together worthless with defined risk. If the option expires between the strikes then losses will incur and if the stock moves above your protection put then max losses will occur at expiration. In a black swan event, clusters of option trades can incur max losses and really jeopardize your profit/loss statement. My goal is limit the losses and not absorb any max losses to optimize risk management.
The further dated call protection leg in a diagonal call spread will allow you to sell-to-close the leg to extract value from the trade if it goes against you. If there's a week left in the further dated option then you still have time premium and if the stock really moves against you then you may have intrinsic value too to partially offset losses. The further dated call protection leg provides more tail end risk mitigation.
Sell a call strike @ $100 22JAN21 and buy a call strike @ $105 29JAN21 to net $50 in premium
A) If the stock stays below $100 at expiration the you net the $50 in premium AND you can sell-to-close the $105 strike for any remaining value to net more than $50 on the trade and capture more than 100% premium capture
B) If the stock trades above $100 then you begin losing money but the $105 strike gains in value and you can sell this $105 strike to offset losses since there's a week left in the contract due to time value. If the stock trades ~$102 at expiration then selling-to-close the further dated call protection will likely circumvent any loss on the trade.
C) If the stock trades above $105 then the $105 strike will gain in value penny for penny above $105 so you can sell this option to avoid any max losses and recapture value from the contract. You would buy-to-close the $100 strike leg to avoid assignment and then sell-to-close the further dated call leg with remaining time value to avoid any max loss situation.
Closing Diagonal Call Spreads:
Managing winning trades is essential so reversing the process via buying-to-close the option leg that was sold-to-open and then selling-to-close the put protection leg that was bought-to-open. This will allow you to close trades early in the option life cycle and capture value that was remaining in the put protection leg.
Options are a leveraged vehicle thus minimal amounts of capital can be deployed to generate outsized gains with predictable outcomes. A diagonal call credit spread strategy is an ideal way to balance risk and reward in options trading. The overall options-based portfolio strategy is to sell options which enable you to collect premium income in a high-probability manner while generating consistent income for steady portfolio appreciation despite market conditions. This options-based approach provides a margin of safety while mitigating drastic market moves and containing portfolio volatility.
Options trading is a long-term game that requires discipline, patience and time. Continuing to stick to the fundamentals with defined risk trades via leveraging small amounts of capital to maximize profits is essential. Diagonal call spreads offer superior risk mitigation in the event option trades challenge your protection legs.
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