Wednesday, 8th September 2010

Diagonal Calls

Written by George Traganidas Topics: Articles, Options, Wealth Building

Fool.com
By Jim Gillies
September 28, 2009

Why use diagonal calls?

1. If you’re mildly bullish on a stock and want to generate income from a leveraged investment.
2. To profit from a range-bound stock.
3. If your underlying stock is chosen well, and you’re handed a little market luck, you can wake up a year or two hence with a significantly in-the-money call option that effectively costs you nothing.

Foolish facts to know:

  • A “diagonalized” position involves two options — one purchased, one written — that differ in both expiration date and strike price.
  • Like a bull call spread, a diagonal call consists of two legs: a purchased lower-strike call and a written higher-strike call, but with the added twist that the purchased call expires as far in the future as possible, while the written call expires in the near term.
  • The maximum loss is simply the cost to set up the position.
  • You’ll need Level 3 or 4 option trading permission (and a margin account) to trade diagonal calls.

You’re already familiar with the concept of writing a call against an underlying stock to produce income, as with a covered call. And you’re familiar with the bull call spread, in which you simultaneously purchase and sell calls with a “spread” between the strike prices. Think of the diagonal call, also known as a diagonal call spread, as the lovely and talented offspring of the two strategies — one that allows you to earn a significant profit while harboring the added potential for serious capital gains down the road. And you don’t need to be more than mildly bullish on the underlying company.

To set it up, you buy (“buy to open”) long-term (almost always LEAPS) “in-the-money” call options (rather than purchasing the stock, as with a covered call) and write (“sell to open”) a nearer-term call with a higher strike price; then, provided your underlying stock and the long-term call option are chosen well, and the market cooperates, you seek to repeatedly write these shorter-term calls with higher strike prices throughout the life of your purchased calls. But be warned: Diagonal calls retain significant (leveraged) downside if the underlying stock craters, and because you own options rather than the stock (as with a covered call), your interim losses can be substantial. Still, applied judiciously, diagonal calls can make even the largest, lumbering blue chip look exciting. Let’s start with the basics.

What Is a Diagonal Call?

The general rules for diagonal calls are:

  • The purchased call leverages the gains on the underlying stock, while the written call reduces your overall cost and increases the leveraged returns. However, no free lunches: It does this by reducing your gains above the written call strike as compared with a covered call.
  • Always match the number of higher-strike calls written with the number of lower-strike calls purchased to mitigate the downside risk exposure of the written calls.
  • This is not a “set-and-forget” trade; you need to actively manage the short-term written calls to maximize gains (or mitigate losses). You may be (and are hoping to) writing multiple short-term calls throughout the life of the long-term purchased call.
  • Ideal candidates are stable blue-chip stocks that will let the options strategy do the heavy lifting for enhanced returns. I favor big companies (a market cap of at least $10 billion, preferably at least $25 billion) with low debt-to-capital ratios and a history of strong returns on equity, free cash flow, and earnings-per-share growth.

How It Works

To see a diagonal call in action, suppose you have a stock trading at $24.50 with the following options available:

Strike Price Expiration Option Premium
$20 28 months* $8.15
$26 2 months $0.95

*LEAPS

To set up your diagonal call, you would purchase (“buy to open”) the $20 LEAPS, and then write (“sell to open”) an equal number of the $26 calls. The net cost of the position is $7.20 per share.

What’s Next: The First Interim Period

When your written call reaches expiration in two months, it will retain only intrinsic value, while the purchased call will have significant remaining time value. The stock price at that time will dictate your follow-up action.

We can use hypothetical future stock prices to forecast the purchased call’s value at this time. Using a Black-Scholes option-pricing model, which we’ll cover in more detail later in Options U., the following prices/profits would exist at short call expiration.

Stock Price At Written Call Expiration

Purchased Call Value @ Written Call Expiration

Written Call Value @ Written Call Expiration

Purchased Call Profit @ Written Call Expiration

Written Call Profit @ Written Call Expiration

Total Diagonal Call Profit @ Written Call Expiration

Interim Return on Investment (ROI)
$18 $3.70 $– ($4.45) $0.95 ($3.50) (48.6%)
$20 $4.90 $– ($3.25) $0.95 ($2.30) (32%)
$22 $6.22 $– ($1.93) $0.95 ($0.98) (13.6%)
$24 $7.66 $– ($0.49) $0.95 $0.46 6.3%
$26 $9.18 $– $1.03 $0.95 $1.98 27.5%
$28 $10.78 ($2) $2.63 ($1.05) $1.58 21.9%
$30 $12.44 ($4) $4.29 ($3.05) $1.24 17.2%
$32 $14.16 ($6) $6.01 ($5.05) $0.96 13.3%

When your initial written call expires, there are three possible outcomes:

1. If the stock price is the same as the written call’s strike, you earn the maximum profit for what we’re calling this interim period. This is because both the intrinsic value and the time value of the written option are zero. (However, in practice, we would roll the call forward if the stock price was hovering around the written call’s strike price.)
2. If the stock price finishes above the written call’s strike at expiration, we still profit, albeit at a lesser rate the further the stock climbs. In extreme cases, the stock price can run so far that the overall position turns into a loss. However, we’d most likely close the position before ever reaching that point.
3. If the stock price is below the written call’s strike at its expiration, we can enter a loss position fairly quickly. However, because we still own that long-term call, we can write subsequent higher-strike calls against it to mitigate our loss.

Graphically, we depict the profit potential of a diagonal call as:

Diagonal Call

Subsequent Steps: How Diagonal Calls Can Work Out Really Well

Arguably, the best outcome from a diagonal call sees the written call expire worthless, with the stock price just below the written call strike at expiration. You get (near) the maximum profit for the period, and can then write a new near-term option at a higher strike (allowing for more upside appreciation of your underlying purchased call); then, that call expires worthless near its strike, after which you write a third call, and so on.

Circling back to our example, imagine that in two months, the stock price is $25.75. Our original $26 written call expires worthless. Now, the two-month $27.50 strike calls would sell for about $0.80 — so we can write these, bringing our total cash from call writing to $1.75, and we repeat the waiting game. This second written leg increases our total potential return (to 59% if the stock price ends at the newly written call strike at expiration), decreases our lower break-even price, practically eliminates the potential for an overall loss if the stock runs away on us, and still leaves us two years to continue writing — ideally ever-higher striking — calls.

Thus, it’s possible that you could completely recover all of the cash you initially put into the position. If you’re doing this into a steadily rising market, on a solid, steady underlying stock, you can end up with an essentially free deep-in-the-money call option, which you can sell or exercise at your leisure.

What Can Go Wrong?

We’re looking to make some pretty hefty gains with a diagonal call, but remember, there are no free lunches! Those prospective gains come at the cost of levered downside losses (in other words, a diagonal call position suffers more as the stock declines than does simple stock ownership. Our profit suffers as the written call rises in value, versus the capped profit of a covered call, or the unfettered profit of simply owning the underlying stock.

This is why we recommend applying this strategy to big, stalwart blue chips. Such companies, if you’ve selected well, will not run away and hide on you.

You also need to pay extra attention to a diagonal call; if it looks like it’s going to be well in-the-money, it may perhaps be better to close early with a decent profit rather than hoping for the stock to come back.

Finally, things can become … pear-shaped. Imagine our stock fell to $12 at expiration of the first written call. That call will expire worthless, providing but mild comfort when you realize you’re left with a 26-month LEAP that’s now significantly out-of-the-money, and you’re unlikely to find prices on new calls to write that would allow you to profitably exit the position. You’re stuck — either you write a call for income that will practically lock in a loss (and hope the stock rises slowly enough that you see a series of such calls expire worthless), or you sit with your now out-of-the-money call and hope the stock goes back up such that call writing again becomes profitable. Either way, when the word “hope” makes it into your investment thesis, something has gone wrong.

Closing Early/Follow-up Action

We’ll rarely hold our purchased call all the way to expiration (if we do, it’s because we’ve had a nicely cooperative stock and are now significantly in-the-money). Most of the time, we’ll “sell to close” our purchased call, then use that money to buy back the written call in the event the stock price has moved significantly past the written call’s strike — ideally, this is delayed as long as possible, and we have a whole string of “expired worthless” written calls in our wake. We’ll also consider closing the position if something has changed for the worse with the underlying business.

Bottom Line on Diagonal Calls

It’s best to use diagonal calls on steady blue-chip companies, leveraging their slow and steady progress to gain outsized returns. We’ll target attractive returns-on-investment, while ideally managing our positions to nurture and grow a few “free” in-the-money calls along the way. The lower up-front investment and potential eye-popping returns make us willing to shoulder the leveraged loss potential on the downside, while ceding some of our upside gains.

Diagonal Call vs. Covered Call: Maximum Profit

Covered call: Your maximum profit occurs at any price above the written call’s strike.

Diagonal call: Your maximum profit occurs at the written call’s strike, after which it tapers off, back toward zero. In fact, it’s possible for the underlying stock to rise sufficiently during the lifespan of the written option so as to create an overall loss on the position.

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4 Comments to Diagonal Calls

sunil kalla
12 October 2013

hi George
great article.

one question.
so stock trading at 20.
you bought 24 months out ;leap strike price $ 15 ( deep in the money)
now you sell next month 25 call
if stock is trading at 26 at expiration you will have
1. iniial premiun but
2.will what will happen to your leap. will it be taken away and if yes at what price?

regards,

sunil

admin
29 October 2013

Sunil,

When you buy an option you have the freedom to act (if you like) and when you write the option you have the obligation to act. Since you have bought the leap call, it is up to you to exercise it or not. If you choose to exercise it, then the price will be $15, because that is the strike price.

Specifically for the example above, since the 25 call has expired in the money, the buyer of the call will exercise it and you will have to provide her the stock at 25 and not at 26 that is the market price. Since you have the leap for 15 then you can buy the stock from the market for 15 and sell it to the buyer for 25. You get to keep the spread of 10 as an additional profit.

I hope that this makes sense. Let me know if you have any more questions.

Regards,
George

Mai
22 March 2017

How do you calculate the maximum loss on a diagonal call spread if you “buy it” for a small credit?

admin
6 April 2017

Mai,

As the post says in the introduction, “The maximum loss is simply the cost to set up the position”.

Regards,
George

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