Description:
This is a diagonal spread consisting of a long position in a deep ITM call option with a strike price K1 and TTM T′, and a short position in an OTM call option with a strike price K2 and shorter TTM T < T′. This is a net debit trade. The trader’s outlook is bullish.
At t = T let V be the value of the long call option (expiring at t = T′) assuming ST = K.
If at the expiration of the short call option the stock price Sstop−loss ≤ ST ≤ K2, where Sstop−loss is the stop-loss price below which the trader would unwind the entire position, then the trader can write another OTM call option with TTM T1 < T′. While maintaining the long position in the call option with TTM T′, the trader can generate income by periodically selling OTM call options with shorter maturities. In this regard, this strategy is similar to the calendar call spread. The main difference is that, in the diagonal call spread the deep ITM call option (unlike the close to ATM call option in the calendar call spread) more closely mimics the underlying stock, so the position is more protected against a sharp rise in the stock price.
