"A diagonal option strategy is like crafting a masterpiece - combining time, direction, and volatility into a symphony of calculated risk and reward."

— Anonymous

Introduction to Call Diagonals

A long call diagonal spread is a versatile and powerful options strategy that leverages the combined dynamics of implied volatility, time decay, and directional price movement. By simultaneously buying a long-term call option and selling a short-term call option at a higher strike price, traders can create a strategy that offers both income and potential for capital appreciation.

This lesson will walk you through the essentials of setting up, analyzing, and managing a call diagonal trade. By the end, you'll have the confidence to include this strategy in your trading arsenal, turning market analysis into actionable trades.

Key Concepts of Call Diagonals

1. Structure of a Call Diagonal

• Buy: A long-term call option (LEAP) with an expiration several months or years in the future. This option gives you the right to purchase the underlying asset at a specific price, benefitting from long-term price appreciation.
• Sell: A short-term call option with a closer expiration and a higher strike price than the one purchased. This generates income to offset the cost of the long-term call.

2. Profit and Loss Dynamics

The profit and loss (P&L) profile of a call diagonal resembles a "hump" centered around the strike price of the short call. The maximum gain occurs when the stock’s price at expiration of the short call is near the short strike. The long-term option retains significant time value while the short-term option expires worthless.

Step-by-Step Guide to Setting Up a Call Diagonal

1. Analyzing the Underlying Asset

Begin with thorough technical and fundamental analysis:

• Trend Analysis: Look for bullish trends or indicators suggesting potential price appreciation.
• Volatility Assessment: Check implied volatility (IV) levels. Higher IV on the short-term option can enhance the income generated.

2. Choosing Expiration Dates

• Long Call: Select an option with at least 6 months to 2 years until expiration. LEAPs are ideal.
• Short Call: Choose a short-term expiration, typically 7-30 days. Shorter expirations offer quicker time decay and more frequent adjustments.

3. Selecting Strike Prices

• Long Call Strike: Slightly in-the-money (ITM) options often balance cost with exposure to price movement.
• Short Call Strike: Choose an out-of-the-money (OTM) strike where you believe the stock price may reach but not exceed by expiration of the short call.

Example Setup

• Underlying Stock Price: $14.00
• Buy: January 2026 $10 call for $650
• Sell: 8-day $14 call for $14.00

Managing the Trade

1. Profit Target and Exit Criteria

• Max Gain: Achieved when the stock’s price at short call expiration is near the short strike ($14 in this example).
• Adjustments: If the stock price exceeds the short strike significantly, consider rolling the short call to a higher strike or later expiration.

2. Handling Adverse Moves

• Stock Drops Below Long Call Strike: The long call retains time value; consider holding the position.
• Stock Rises Sharply: Close or roll the short call to avoid assignment risk while locking in profits from the long call.

3. Metrics to Watch

• Theta (Time Decay): The short call’s time decay benefits the position.
• Delta (Directional Sensitivity): Keep an eye on delta changes as the stock moves toward or away from the strikes.
• Implied Volatility: Changes in IV affect the pricing of both options.

Advanced Considerations

Optimal Timeframes

• Data shows that buying a long call 60 days out and selling a short call 30 days out can provide a balanced risk-reward profile. Experiment with different timeframes based on your market outlook.

Rolling Strategies

• As the short call approaches expiration, roll to a new short call with:
  • A higher strike if bullish.
  • A closer expiration for quicker income capture.

Return Potential

• The example trade generated a potential 2% return in 8 days. While this may seem modest, compounding such returns over time can lead to significant annual gains.

Summary

Call diagonals are an excellent way to combine income generation with longer-term bullish outlooks. By understanding the nuances of this strategy—from setup to management—you can position yourself to capitalize on market opportunities with calculated precision.

In the next lesson, we’ll explore put diagonals and how they can complement your trading toolkit in bearish scenarios.

As an additional resource, there is a video covering this entire topic which may include some additional content. Click below to view it.