Let us learn about the call diagonal option strategy today. This is a risk-defined strategy with a limited potential to profit. This strategy earns profit by the time decay factor and price decline of the underlying stock.
Call diagonal spread has two call option contracts. The bearishness and bullishness are based on how they are used in the strategy.
A diagonal spread is bearish when traders sell a short-call option and buy a long one at a high strike price and a later expiry.
A bearish call diagonal spread is the combination of call credit spread and call calendar spread and is generally used to bring in some credit.
The trader can earn a profit via this strategy if the stock closes at a price which is below the short call during the front month expiry. The back-month long call will serve as protection and help define the position's risk.
Market outlook of the Call diagonal spread strategy:
Traders enter the call diagonal spread when they believe that the underlying asset's price will be neutral or bearish in the near term. The near-term call option gets an advantage from the price fall of the underlying stock. The long call option will retain the value due to the high time frame.
The main purpose of entering this strategy is to allow the short call option to expire worthless at the first expiry date, and the extended call options would still have the extrinsic value left. At this stage, traders may choose to close the position or wait for the stock to take a reverse turn and go higher. To bring in more credit, traders may sell another short-call option.
Setting up a call diagonal spread strategy:
A call diagonal spread strategy is made by combining bear call credit spread and call calendar spread. Traders can create a call diagonal spread by ordering a sell-to-open (STO) call option and a buy-to-open (BTO) call option at the high strike price and having a later expiry date.
The traders generally open the call diagonal strategy to gain credit on the position; a small debit is often paid. The premium received or paid at the initial stage is decided by the width spread between the two strike prices and the time they have till the expiry. The higher the time the contract has in expiry, the more expensive that contract would be, and it will also decide whether the position is opened for the debit or credit.
The highest risk in this strategy is width spread minus the initial credit received; If the short call option contract expires ITM at the front-month and if the trader chooses to close both the contracts. If short calls expire OTM, the trader may sell the long call with its remaining extrinsic value. In this case, the total of the initial credit received and the credit received by selling the long call options will be the highest profit.
How to enter the call diagonal spread strategy?
As we discussed earlier, a call diagonal strategy can be entered using a sell-to-open (STO) short call and a buy-to-open (BTO) long call option contract.
Suppose a stock is currently being traded at ₹50. A trader believes that the stock price will stay below ₹50 only in the near future; in such case, he can enter the call diagonal spread strategy by selling a call option at ₹50 and buying a long call option at ₹55 at a later expiry date.
Understanding the diagram of call diagonal spread:
The diagram of the call diagonal strategy is variable and has various outcomes based on when the trader decides to leave the position.
The highest risk is predefined upon entering the position: the spread's width minus credit received.
If the stock closes at a price above the short call option during the front month expiry, the trader has to exit the position to avoid the assignment.
Trader may hold the long contract till its expiry if he thinks that the price will increase or may sell it out.
If the stock closes at a price below the short call's strike price during the front month expiry, which is the main goal of the strategy, the short call option contract will expire worthless, and the long call option will have its intrinsic value left. Here traders may choose to stay or exit the position.
Considering the above values, imagine a stock is traded at ₹50, and a trader believes that the stock will remain within that range only and thus sells a call option at ₹50 and buys another call at ₹55, expiring at a later date. If, by entering this position, the trader has gained the credit of ₹1, then the highest loss will be limited to -₹400.
The highest profit depends on whether the trader stays or exits the position.
How to exit from the call Diagonal strategy:
The stock price at the time of expiry plays a major role in deciding whether or not to exit from the strategy. In order to exit the strategy, traders may reverse the trade by using Sell-to-close (STC) on the long call option contract.
Additional notes on call diagonal spread:
The time decay factor or theta has a positive impact on the front month short call option and a negative impact on the back-month long call option contract.
The implied volatility also has a mixed effect on both the contracts of the spreads.
In adverse market situations, the short-call option can be bought and sold again to limit the risk and increase the potential to profit.
Thus, we have seen what strategy a trader can use when the contract is expected to stay below a specific price. And how, by combining short-term and long-term contracts, you can earn profit.
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