The Short Call Diagonal

Something I need to address before I get into the details of this post. Nobody who reads this post should ever attempt to trade this, or any strategy, based on my or someone else’s experience! I’m here to educate traders based on my many years of trading experience, not to recommend trades. Take what you learn here and do your own study and research. Simulate the trades using a paper money account instead of risking your own funds. Do the work! Also, stop paying for services that don’t provide proof that the person charging you for their service is a profitable trader. Most services make money by selling their service, not from trading!

Why the short Call Diagonal trade? Simply said, selling Call spreads on the major indexes generates more premium (bigger credits) than selling Put spreads. That’s due to option skew where further OTM (out-of-the-money) Calls are relatively cheaper and further OTM Puts are relatively more expensive then ATM (at-the-money). That makes selling Call spreads (expensive) and buying Put spreads (cheap) as the better value. The problem with selling Call spreads and/or buying Put spreads on the indexes is that position is short Deltas or a bearish position. That’s fine when the price of the index is going down but disastrous if price is going up, which it does the majority of time. Also, when selling Call Vertical spreads, the maximum amount of potential profit is equal to the amount of credit collected when the trade was placed. Often that amount of potential profit is less than the potential loss. I prefer trades where I can make more than the initial credit received and the short Call Diagonal offers that potential. There are variations on the short Call Diagonal as I discuss in the updates at the bottom of this post so be sure to read the whole post before drawing any conclusions!

All of the SPX short Call Diagonals mentioned in this post are Friday/Monday expirations. That means the short Call is positioned on a Friday expiry and the long Call is positioned on the following Monday’s expiry. There is exactly 3 days difference between the expiry of the short and long Calls. The reason I utilize those expiry’s is due to the option skew mentioned above. It is typical for the Friday Calls to have a higher implied volatility (IV) than the following Monday. That means the Friday Calls that I’m selling are relatively more expensive than the following Monday’s Calls that I’m buying. The key word there is relatively! The actual price of the Monday Calls of the same strike as the Friday Calls is always going to more expensive because it has 3 more days of time value. The way I can buy Fri/Mon Call Diagonals for a very small debit or even collect a credit is by going further out in time (20-30 DTE) and by selling the Calls closer to ATM than the long Calls that I’m buying. The further out in time and the wider the difference between the short Call and the long Call the smaller the debit or the greater the credit. Below is an example. If I choose an approximately 2% move higher as the target price then the 5-point wide short Call Diagonal with 6 DTE would be $.85 debit, with 13 DTE it would be $.60 debit and with 20 DTE it would be just a $.15 debit. That represents the value of time risk for those short options!

Now is as good of a time as any to bring up a an important point regarding these trades. Look at the risk profile above. See the margin requirement? It’s $500 for a 1-lot (contract) short Call Diagonal. That’s not just a random number, that’s the actual risk of this trade! If SPX moved higher quickly and gained 1-2% in just a day or two not only would I have an open loss but if I continued to hold the position without making an adjustment or exiting the trade I could quickly find my self with a growing loss that could equal $500 plus the cost of the debit that I paid to enter to enter the trade. Throw in some slippage trying to exit the trade, and some commissions, and my loss could approach $520-$550. Exiting a trade where price isn’t doing what I expected it to do is always a good potential solution but I also frequently use a hedge in these positions if I expect SPX to rally.

If I was trading a single contract (1-lot) SPX short Call Diagonal then I could use a long Call on /MES (the micro futures contract based on SPX) to hedge the position assuming I saw a chart setup that indicated it was good location for a long Delta SPX trade. See risk profile below.

If I wanted to change the position into an even more bullish position I might use 2 /MES long Calls.

Now is a good time to mention the problem with the risk profiles you’ve just been viewing. A typical risk profile typically overstates the amount of potential profits, especially in regards to time spreads, often by a factor of 2 or more! That’s often due to the effects of Vega (if you don’t know what Vega is, do some research!) but it could also be to entice traders into trading. Think about who would profit from traders trading! 🤔 The best way to estimate the potential maximum profit of a Fri/Mon spread is by using the SPX options chain just prior to the close of trading on any given Friday. The value of the following Monday options at that time is an exact representation of the maximum value that Fri/Mon spread could be worth. Below is my post on Twitter (X) from this past Friday with less than an hour left in the trading day.

The 10-point wide spread that was bought for a $.20 credit was worth $4.80. That’s a nice return but still much less than what the risk profile suggested when I placed the trade. Below is the SPX option chain showing the value of the Monday options at the close on the Friday preceding that Monday. This is with a VIX of 18 which has a big effect on the value of options! The higher the VIX generally the more expensive the option value. Look at the value of the OTM Calls.

If SPX was within 40-50 points of my target price with a short Diagonal (target price is always the strike of the short Call with Friday expiry) when the Friday Calls expired then the long Monday Calls would be worth $.35-$.75. If, instead of a short Diagonal spread, I had bought a Calendar spread for around $3 then I would have a big loss. SPX would’ve needed to be within about 25 points of the Calendar’s target price to make any profit at all if I paid $3 or more. If I had instead paid a $.30-$.40 debit for a 5-point wide short Diagonal and SPX was within 40-50 points of my target price then I’d actually have a small gain. If I had received a $1 credit on a 10-point wide short Diagonal then I’d have a very good gain. If however I was lucky enough that SPX closed right on the short Call strike at Friday’s expiry then the 5-point wide short spread would be worth $9.35 and the 10-point wide spread would be worth $7.15. Because the area where those maximum gains occur is just 5-10 points wide in SPX I rarely carry my positions into the close of trading on expiring options. I’d much prefer take most of my gains prior to that to reduce the Gamma risk. I’ll often trade multiple-lot positions and I’ll exit the position in tranches of 20% of the position and only sometimes carry the remaining 20% into expiry.

To further the point of overly optimistic risk profiles, see the SPX triple Calendar below. It looks like it’s a big winner if SPX is anywhere in the range of 1-2% higher over the next 3 weeks. However, now you know that the maximum potential value if SPX expires on Nov8 exactly at one of these three strikes; 5900, 5950, or 6000 is about $12. That’s approximately double the $6.50 cost of buying the triple Calendar. Not bad. If however SPX doesn’t close right at one of the the short Call strikes then the triple Calendar could lose money. For instance, a SPX close near 5925 or 5975 and the Calendar is likely worth around $2.50 which isn’t great for something I paid $6.50 for. Not to mention that I’d likely be taking a loss on any Calendar that is ITM (in-the-money). The further ITM an option becomes the less extrinsic value it has (the Friday and Monday options become closer in value) and exiting a deep ITM Calendar spread can be very costly as the bid/ask spreads can get very wide! So in this example I could likely take a loss on the ITM Calendars meaning the value of the triple Calendar could expire with around a $4 loss. Now, compare the risk profile below to what the actual position would be worth if SPX expires Friday, Nov8 at 5975. Hmmm…I don’t see that risk profile dipping into the loss area, do you? It looks like I’d have a big gain! Now you’re beginning to understand the truth about risk profiles!

So the key to having a profitable trade is directly related to the cost of the trade. While that seems ridiculously obvious you’d be surprised how many traders don’t think in those terms. Again, I blame the risk profile for much of that but I have to move on now from complaining about deceptive risk profiles! I’ll throw one more potential structure out to get you to think about ways to play for upside potential profits while keeping the net cost low. Below is my current risk profile. Here I’m focusing on the 100-lot, 10-point wide (5990-6000) short Call Diagonal with Nov 8/11 expiry. That was bought for $1.25 credit. There’s no downside risk and, if SPX is below 5990 at expiration, the minimum profit is $12,500. What if I spent about 80% of that credit on Nov 1/4 6000 Calendar spread? That way if SPX rallied up into near 6000 by Nov 1st that Calendar would show a potentially large profit while hedging the short Deltas of the 10-point wide short spread with Nov 8/11 expiry. I’d still retain some credit so I’d have no downside risk and it wouldn’t increase the margin requirement. That’s just one potential variation that should cause you to think about possibilities of using one position to hedge another.

That’s all I have time for today. I’ve no doubt forgotten to mention some things but that’s the way it goes. If you have questions regarding this post or just general comments leave them down below or on Twitter (X) @VegaOptions.

10/26 Update: I’ve had several questions regarding the optimal DTE to place short Call Diagonals. While nothing is absolute given the uncertainty of predicting the implied volatility of the options, the risk profile below can give you an idea on the increase in value one might expect. I did cover this briefly in the original post but it’s an important topic so here you go. If I initiated a 10-point wide Fri/Mon spread with 27/30 DTE the credit would be $1.30. 1 week later, if nothing significant happened to SPX or VIX, that spread would have profited by $.20. If, instead, I initiated the same spread with 20/23 DTE for $1.10 then 1 week later that spread would’ve profited by $.95. Clearly, in this example, it would be better to initiate the trade with 20/23 DTE. If you’re considering the risk/reward benefits of this type of position in the future I encourage you to do this analysis before any trade!

10/27 Update: In response to a great question from Mikey (see question section below) in regards to a comparison of the short Diagonal versus the short Butterfly spread I’ve added another risk profile below. It actually compares 3 different trade structures because I’ve added another one to the mix. On the risk profile it’s shown as custom but, if you’ve followed me for awhile, you’ll recognize the structure as what I refer to it as a RS+ (Ratio Spread +) which is discussed more in-depth here from a September 2022 blog post. To quickly summarize the comparison; the Butterfly generates the largest credit, the Diagonal offers the better return if price gets near but fails to reach SPX 5880 (in this example) and the RS+ offers the greatest payout if SPX rallies past the 5900 short strike.

Many of my positions are combinations of trade structures and the current level of the VIX also plays into my decision process. There are many posts on this blog and, each of the strategies has both positives and negatives so take the time to learn each one to decide how they might fit into an option portfolio. And, once again, don’t trade ANY strategy until you fully understand all of the associated risks!

11/2 Update: Most of my trades are initiated with the next trade in-mind. Yesterday I identified an area on the SPX chart where I wanted to add some short (bearish) Deltas but overall I wanted to continue to build up a bullish position that would profit from a potential rally over the next 2-3 months. As long as the positions that I hold are initiated for net credits or very small debits then, even if that rally doesn’t materialize, my P&L will likely increase. Trade #1 was the short Call Diagonal I bought that generated a $5.50 credit. On the 50-lot order size that was a $27,500 credit. As price moved lower towards the 50%-61.8% Fib retracement of Friday’s rally, which was good location for a bullish trade, I spent $30,500 ($61 debit) on trade #2. That trade was simply a 10-lot of 100-point wide Call Vertical debit spreads plus another 15-lot of the short Call Diagonals from trade #1.

Below is the risk profile of the resulting position. Again, I’ll remind you that risk profiles are wildly inaccurate in most cases. In this particular case it shows the maximum potential profit is around $250,000 and there is no way that’s going to happen! It’s much more likely that the maximum profit will be around half of that amount. Keep reading below to see how I calculate that.

The maximum profit of the 100-point wide Vertical Call spread is $100 (less the cost of the spread). With SPX options you multiply the cost of the option, as shown in the option chain, by 100 so an option that is priced at $1 is actually worth $100. That’s $1,000 for 10 points or $10,000 for a 100-point wide spread. I hold a 10-lot position size so the maximum that 10-lot spread could be worth is $100,000. If, by some stroke of luck, SPX closes exactly at 5900 on Nov 15 expiry, I make $100,000 on the Vertical spread and those short 5900 Calls expire worthless and I still own a 65-lot of Nov18 5925 Calls. Let’s use the options chain from earlier in the post to estimate a value of those options. They would be 25-points OTM at Friday’s expiry. Hmm…looks like they would be worth around $2.60 assuming the IV of SPX doesn’t change too much. So $2.60 x 100 x 65 (lot) = about $17,000. Not bad but $117,000 total for the position is far less than the $250,000 shown in the risk profile. In fact, it’s about half the amount! So now we see another example of why traders who buy SPX Call Diagonals or Calendars almost always lose because they are typically willing to pay too much for the spreads based on the risk profile and the risk profile is over promising them a potential return!

11/3 Update: On Friday Oct18 I made 2 trades in constructing this position. At that time there was 21 DTE on the Nov8 short Calls. The 100-lot of the 10-point wide short Call Diagonals was bought for a $12,500 credit and the 50-lot of 5-point wide short Call Diagonals was bought for a $250 debit. The net credit for the position was $12,250 and that is the minimum profit if SPX is below 5945 at Nov8 expiry.

Clearly, even if the potential profit is less than half of what is shown on the risk profile, I can make a lot more if I hold the position into expiry and SPX has a strong rally this week. If SPX instead continues down then the worst I can do is make $12,250 so what do I have to lose by holding on thru the week? First, there is still a risk that SPX can experience a strong rally beyond the 5945 short strike (the U.S. presidential election is on Tuesday) and I could start losing money there but that’s less likely at this point since 5945 is more than 3% higher than current price). The most likely risk is to my $28,750 open profit. If SPX continues lower then the open profit will approach the minimum profit meaning my most likely risk now is $28,750 – $12,250 = $16,500. In order to mitigate that risk I’ll begin exiting the position early this week and continue throughout the week leaving only about a maximum of 10%-20% of the position size in place by Friday.

11/8 Update: This is an update to the short Call Double-Diagonal position shown (above) in the 11/3 update. I waited until later this (expiry) week to begin exiting the position because I was effectively hedging the position with /ES Calls and SPX was in a strong rally which was benefitting the position. The order fills are shown below.

The initial net ‘cost’ was a $12,250 credit and I collected another $31,750 in credits in exiting the position for a total profit of $44,000. I’ll let the TOS platform total the trades up for you (below) so that you don’t have to do the math to check on my calculations!

The initial margin requirement was $125,000 so those 2 trades resulted in a 35% return on risk in 3 weeks. One final note on that position. What if I didn’t start exiting the position on Wednesday of this week and instead held on into today (Friday expiry)? With SPX at 5995 this afternoon the total profit of the initial position would’ve been just over $22,000. Not bad but half of my actual profit so…not really very good. I’ve found that it seldom pays to be greedy as a trader. These short Call Diagonals are designed to be initiated for credits or very small debits so that a trader can collect profits along the way towards expiry instead of trying to hit a home run.

I added a short post that includes 4 different SPX option chains and here’s the link. It will give you an idea of some potential maximum values of a 5 or 10-point wide SPX short Call Diagonal spread.

I think that’s likely my last update on this strategy unless there are additional questions down below. Another reminder to not do this strategy just because I showed you a winning trade or two here. Use this post as educational opportunity to open your eyes to a strategy that you likely won’t see anywhere else. Study it, test it out on paper money without risking your own capital, and see if it makes sense for your trading.