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How to Write a Diagonal Bull Call Debit Spread

By Edited Jul 1, 2014 0 0

While conventional spread trades effectively balance reward and risk for a finite timeframe, diagonal spreads - sometimes called time spreads - let a trader take advantage of an accurate prediction of price movement over time. A diagonal bull call debit spread is a "neutral now, bullish" later trade. The strategy requires shorting a short-term call option with a strike price at least two strikes above the current stock price, and the purchase of a longer-term call option with a strike price below the one shorted.... usually just one strike above the stock's current price. The net difference between the two position requires money up front, or a debit, but will generate even more in profits later when it's closed out.

Things You Will Need

* Option quotes * Stock price forecasting tools * Option-approved brokerage account

Step 1

Choose a stock (or index) that you expect to remain flat for a specific timeframe, and then move higher. For instance, assume XYZ stock will remain at its current price of $42 per share for three months, and then begin to rally to $52 - or higher - within six months.

Step 2

This is the more permanent of the two legs of the time spread. If the prediction suggest the underlying stock will rise for six months, then the option should expire six months or more from the trade's inception. If the stock is expected to rally for four months, then only four months of time is needed. This call's strike price will also, ideally, be at or just a bit above the current price of the stock. Any lower, and it may cost too much. Any higher, and it may offer too little profit potential. Sticking with the example of the XYZ shares at $42, a six month bullish projection would mean the purchase of a call expiring six months from now, with a strike price of $45. The call would cost about $5, or $500 per contract.

Step 3

This less-permanent leg of the trade is the call you're shorting. This one should expire before the long call will, but should have a strike price higher than the long call does. This call should expire before the stock actually starts to rise. For instance, if you think the stock will start to rise in three months, this shorted call should expire in two months. With the XYZ trade, if XYZ is expected to rise in four months, then a three-month expiration is on order. The strike price should also be $50 - above the other call's strike price. This will cost about $2, or $200 per contract.

Step 4

The six-month, $45 strike call contract will cost $500 per contract, while the three-month $50 strike call - which is sold/shorted - will create income of $250 per contract. The net difference creates a cost or debit of $250 per contract to the trader.

Step 5

From this point, there are three possible outcomes (or several variations thereof). The worst case scenario is that XYZ shares stay under $45 for six months, and both calls expire worthless. The best case scenario is that XYZ shares move above $50 within six months, but more than two months. The long call can be sold at any price during that time, and the theoretical profit is infinite. The only downside is the $250 the trade initially cost. If XYZ moves to , say $70, before two months have passed, the $45 call could be sold for $25 (or $2500 per contract). However, if the short call position is still open, the trader may have to buy it back for $20, or $2000 per contract. Thus, the maximum gain is $500 in this scenario. This is why it's important that the near-term option expire before a big move is made... it can limit profits otherwise. If XYZ shares end up moving somewhere between $45 and $50 over the following three to six months, then the profit - or the net loss - will be minimal either way. Time, the stock's price, and volatility will determine the profitability in that scenario. In short, diagonal bull call spreads are designed to eventually be straight call trades, but with small cash-kicker up front to offset some of the initial costs. The kicker, however, also effectively locks the trader into the position for a while.... until that short option expires. After that, the option trader simply owns a long call with infinite upside.

Tips & Warnings

Total commission costs may be greater due to additional trades. The maximum profit potential is limited (though so is the risk).
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