The diagonal bull call spread strategy involves buying long term calls and simultaneously writing an equal number of near-month calls of the same underlying stock with a higher strike.
This strategy is typically employed when the options trader is bullish on the underlying stock over the longer term but is neutral to mildly bullish in the near term.
|Diagonal Bull Call Spread Construction|
|Buy 1 Long-Term ITM Call|
Sell 1 Near-Term OTM Call
The ideal situation for the diagonal bull call spread buyer is when the underlying stock price remains unchanged and only goes up and beyond the strike price of the call sold when the long term call expires. In this scenario, as soon as the near month call expires worthless, the options trader can write another call and repeat this process every month until expiration of the longer term call to reduce the cost of the trade. It may even be possible at some point in time to own the long term call "for free".
Under this ideal situation, maximum profit for the diagonal bull call spread is obtained and is equal to all the premiums collected for writing the near-month calls plus the difference in strike price of the two call options minus the initial debit taken to put on the trade.
The maximum possible loss for the diagonal bull call spread is limited to the initial debit taken to put on the spread. This happens when the stock price goes down and stays down until expiration of the longer term call.
In June, an options trader believes that XYZ stock trading at $40 is going to rise gradually for the next four months. He enters a diagonal bull call spread by buying a OCT 40 call for $300 and writing a JUL 45 call for $100. The net investment required to put on the spread is a debit of $200.
The stock price of XYZ goes up by $1 a month and closes at $44 on expiration date of the long term call. As each near-month call expires, the options trader writes another call of the same strike for $100. In total, another $300 was collected for writing 3 more near month calls. Additionally, with the stock price at $44, the OCT 40 call expires in the money with $400 in intrinsic value. Thus, in total, his profit is $400 (intrinsic value of the OCT 40 call) + $300 (additional call premiums collected) - $200 (initial debit) = $500.
If the price of XYZ had declined to $38 and stayed at $38 until October instead, both options expire worthless. The trader will also be unable to write additional calls since they are too far out-of-the-money to bring in significant premiums. Hence, he will lose his entire investment of $200, which is also his maximum possible loss.
Suppose the price of XYZ did not move and remains at $40 until expiration of the long term call, the trader will still profit as the total amount of premium collected is $400 while the OCT 40 call cost $300, resulting in a $100 profit.
Note: While we have covered the use of this strategy with reference to stock options, the diagonal bull call spread is equally applicable using ETF options, index options as well as options on futures.
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).
The following strategies are similar to the diagonal bull call spread in that they are also bullish strategies that have limited profit potential and limited risk.
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