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One of the key features of option spread strategies is that they typically can be put on with far less capital than just buying stock or even combining stock with options. Many equity investors employ the covered call strategy to enhance returns and generate income. However, there is a time spread called the diagonal calendar that can be created with much less risk and offer an even better overall return than the covered call.

Just as a refresher, a covered call is constructed by selling an out-of-the-money, in-the-money or at-the-money call against every 100 shares of stock purchased or is already owned in the portfolio. Typically, this strategy is implemented when the trader feels we are in a bullish to neutral market where a slow rise in the price of the underlying equity is anticipated with little risk of decline.

The profit on this type of position is limited to the credit received from the short call option plus the short call strike price of the underlying stock. The breakeven is the price of the stock at initiation minus the short call premium received, while the risk is almost unlimited to the downside below the breakeven all the way to zero. It is this great risk factor coupled with the bigger capital outlay that renders a time strategy like the long diagonal call a far more attractive position in terms of both risk and reward.

The long call diagonal spread is a low-risk strategy that consists of both the sale and the purchase of an equal number of call options with the same underlying stock using different strike prices and different expiration dates. Shorting the front month call option and hedging it by going long a call option that expires at a later month constructs the diagonal call spread. The maximum risk is equal to the net debit of the options. Just like the covered call the option strategist would look to implement the diagonal call spread in a bullish to neutral market where a slow rise in the price of the underlying stock is expected with little risk of decline.

However, there are some other features of the call diagonal spread that makes it a much more attractive strategy when compared to the covered call. The first advantage is that far less money is required to put together the call diagonal spread versus the covered call. Second, the risk involved with the call diagonal is less than the risk associated with covered call. Finally, the return on investment and return on risk is a lot greater than that of a covered call. Looking at an example will help point this out.   

Assume XYZ stock is trading at $82 per share when the trader purchases 100 shares and at the same time sells a covered call with 30 days until expiration for $220.  The risk is $7,980 [$8,200 - $220] and has a maximum profit of $520 if called out [$300 + $220], a 7 percent return. Compare this to the call diagonal spread where the trader purchases 1 long-term 80 call for $920 and sells the front month 85 call for $220. The maximum risk in this position is $700 [$920 - $ 220] and has a maximum profit of $335, which is a 48 percent return on investment.

Note that for time type spreads, an options analysis tool like Platinum is needed to accurately calculate the maximum profit and breakevens. However, this clearly illustrates to the option strategist that in terms of risk and reward, the call diagonal spread can be a far superior strategy than the covered call.

Happy Trading.


Jeff Neal
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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