A calendar spread allows option traders to take advantage of elevated premium in near term options with a neutral market bias. A diagonal spread allows option traders to collect premium and time decay similar to the calendar spread, except these trades take a directional bias. While both strategies will have some delta, a diagonal spread will have significantly more delta (and thus more directional bias) than a calendar spread. Both calendar spreads and diagonal spreads are common option strategies deployed by Market Rebellion’s Chief Technical Analyst, AJ “The Oracle” Monte.
How to Construct a Calendar Spread Step-By-Step
- Purchase a long-dated option
- Simultaneously short sell a nearer dated option in the same stock, with the same strike price
- As time decay takes effect on the nearer-dated short-option (also called the “front money” option), the trader has the option to either:
- Buy-to-close the short-option for (hopefully) less than they paid
- Let it expire (hopefully) worthless
- Roll the short-option to continue exposure to the trade
Traditionally, calendar spreads use the same strike in both options, which makes the profit/loss diagram look like this:
Calendar spreads work best when the stock expires at the short-strike. This is a similar P/L to the short iron butterfly.
However many traders (including Market Rebellion’s AJ Monte) like adding directionality to these trades — and that’s where the diagonal spread comes into play.
How to Construct a Diagonal Spread Step-By-Step
- Purchase a long-dated option
- Simultaneously sell-short a nearer-dated option in the same stock, with the same directional view, but a different strike price.
- In a call diagonal spread, the nearer dated option will have a strike price that is higher than the longer dated option. In a put diagonal spread, the nearer dated option will have a strike price that is lower than the longer dated option.
- Just like the calendar spread, you’re hoping for theta decay and volatility crush to work its magic on the nearer dated option, lowering its value without the underlying stock straying too far from the longer dated strike price. When this happens, you’re once again presented with the same three choices:
- Buy-to-close the short-option for (hopefully) less than you paid
- Let it expire (hopefully) worthless, leaving you with a simple long option from the other half of the trade
- Roll the short-option to continue exposure to the premium collection side of the trade
Ready to start trading? Try Options Oracle. Led by Chartered Market Technician AJ Monte, Options Oracle combines diagonal calendar spreads with technical analysis to set up powerful two-pronged swing trades.
Calendar Spreads and Diagonal Spreads: Compare and Contrast
Calendar spreads and diagonal spreads are two very similar trade structures, but there are distinct situations where one will outperform the other.
Calendar Spread vs. Diagonal Spread: Similarities
- Options strategies used in premium collection. Both diagonal spreads and calendar spreads perform best when near dated options are overpriced (predicting a price move larger than what will actually happen), and are about to decline in volatility.
- Lower cost basis. Both diagonals and calendars are excellent tools for lowering the cost basis of a longer dated option. By successfully selling enough near dated options, an efficient calendar spread trader (or diagonal spread trader) could theoretically own a longer dated option (or even LEAPS) for free.
Calendar Spread vs. Diagonal Spread: Differences
- Directional bias. When you buy a calendar spread, you’re saying you believe that a stock is not going to make a big directional move before the near dated option expiration. When you buy a diagonal spread, you’re saying you believe the underlying stock is going to make a directional move before the near dated option expiration, possibly as high as the strike price plus the premium collected for the short dated option.
- Structure. While both calendar spreads and diagonal spreads involve buying a long dated option and financing the purchase with a near dated option, and both spreads require a debit, the difference is in the details. Calendar spreads use the same strike in both the long dated and the near dated option contracts. Diagonal spreads use different strikes. This sounds minor, but the difference it makes can be huge.
For example, calendar spreads are more of a pure premium-collection play with a minimal amount of delta. You’ll collect more premium and have a lower debit cost. However, while a diagonal spread will cost more (all other things equal), diagonal spreads expose options traders to directional upside potential. That means the spread has two ways to make money — premium collection (whether by theta decay or a decline in volatility) and delta expansion (the underlying stock moves in your favor).
At the end of the day, there are advantageous situations for both styles of “time spread” — but how do these spreads stack up to other methods of premium collection? Let’s look at it from a delta perspective.
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Short Iron Condor, Calendar Spread, Diagonal Spread, Vertical Spread: Directionality
Options are a lot like tools. There are a lot of different types of tools, with many nuanced uses. For instance, imagine you’re assembling a large piece of furniture. You’re given a set of 100 screws. You could use a screwdriver — there would be nothing wrong with that. But if you use a power drill, you’ll probably get the job done more efficiently.
Likewise, when it comes to premium collection, there are a multitude of option strategies that can get the job done. But depending on the exact type of premium collection, the circumstances around the underlying stock, and your directional view, there is likely one style of option strategy that will outperform the rest. The easiest way to separate these styles of premium collection strategies is by delta and directionality.
Short iron condors, calendar spreads, diagonal spreads, and vertical spreads ranked by directionality. Source: Market Rebellion
There’s a little leeway here in the comparison between diagonal spreads and vertical spreads. Technically, both diagonals and verticals have similar payout structures (the long strike minus the short strike minus the premium paid).
However, vertical spreads will generally have a lower barrier to entry because the trader is paying for less time value. That means, all other things equal, a trader will have a higher risk/reward with a vertical spread than with a diagonal spread. Of course, on the other hand, vertical spreads are less about premium collection than diagonal spreads are — and as such, diagonal spreads offer more outlets to collect premium throughout the trade.
For instance, if a trader has opened a vertical spread and the underlying stock moves against the position, the vertical spread will lose value at a faster rate than an equivalent diagonal spread would have. Additionally, in the same situation, a trader holding a diagonal spread could have closed the short leg of their spread for a profit, and reopened another new short leg (otherwise known as a roll) in an effort to “recoup the losses” from their long leg with continued premium collection.
Now that you understand the various nuances between four of the most common premium collection strategies that option traders use to exploit theta decay and IV crush, let’s look at a real life example from Market Rebellion’s premier technical analysis service, Options Oracle.
Real Life Diagonal Spread Example: Diagonal Put Calendar Spreads in iShares Russell 2000 ETF (IWM)
Diagonal calendar spreads are one of the most popular trade structures used in AJ Monte’s Options Oracle. Here’s an example of a diagonal calendar spread trade that he put on in January of 2022 in the iShares Russell 2000 ETF (IWM).
Source: Options Oracle
In the trade above, AJ Monte buys ITM $225 strike put LEAPS (meaning options that expire more than a year from purchase) resulting in a -$34.50 debit and simultaneously sells OTM $210 puts roughly a month away from expiration for a credit of +$4.00 — for a total debit of $30.50. The trade takes a mildly bearish view on the IWM Small Cap ETF, and caps potential profit from the $225 long put at the $210 short-strike until expiration.
A look at the chart indicates that this trade did move in AJ’s favor — by January 18th the IWM fell to $207, $3 below the $210 short-strike. As a result, AJ collected a portion of the premium by rolling the short option to the following month. By March, AJ had lowered the cost basis of his January 2024 $225 strike put LEAPS from an initial debit of -$34.50 to -$24.95. All the while, the longer dated option was gaining value. At the time of writing, those $225 put LEAPS are trading for a mid price of $52.50 — more than twice that of his cost basis.
The Bottom Line: Calendar spreads and diagonal spreads offer a way to sell options and collect premium with limited downside risk. Interested in learning how to trade with help from a Chartered Market Technician? Start slow, with Market Rebellion’s intro to AJ Monte’s technical analysis, Oracle Essential.