Diagonal Spread

Use calls for bullish outlook (call diagonal), puts for bearish outlook (put diagonal). The direction you expect the stock to move determines your choice.

If the stock moves through your short strike significantly, your gains are limited. You can roll the short strike further out to capture more upside, or take profits on the existing position.

A Poor Man's Covered Call (PMCC) is actually a type of diagonal - it uses a deep ITM LEAPS call for the long leg. Regular diagonals use ATM or slightly ITM options with shorter back months.

If stock is below the short strike (call diagonal), the short call expires worthless and you keep the premium. You still own the back month call. Plan to close or roll 5-7 days before expiration.

Your maximum loss is typically the net debit paid. However, assignment situations can create complications. Proper management before expiration prevents most issues.

Strike width depends on conviction and risk tolerance. Narrow width (1-2 strikes): lower debit, lower max profit, higher probability. Wide width (3-5 strikes): lower debit from more premium, higher max profit, lower probability.

Roll when: your thesis is still valid, the trade is working, and you want to continue collecting premium. Close when: thesis has changed, stock moved significantly against you, or better opportunities exist.

Dividends create early assignment risk for short calls. If your short call is ITM and the dividend exceeds the extrinsic value, assignment is likely. Monitor ex-dividend dates and close or roll before.

Ideal location is between your long and short strikes, gradually moving toward the short strike as front expiration approaches. Stock at the short strike at expiration is the perfect outcome.

Theta is highest when stock is near the short strike. As front month expiration approaches, theta accelerates if stock is at the short strike. Gamma risk also increases near expiration.

Monitor the IV differential between front and back months. Backwardation (front > back) often corrects and provides extra profit - excellent entry. Steep contango makes diagonals expensive.

Track total portfolio delta, vega, and theta. Diversify across sectors and directions. Monitor correlation - avoid overconcentration. Consider hedging aggregate delta exposure.

Ratio diagonals (selling more front month than back month) increase income but add naked option risk. Use only with strong conviction and willingness to accept unlimited risk.

Use Monte Carlo simulation across price and vol paths, weighting outcomes by probability. Factor in transaction costs, assignment probability, and management costs.

Call skew (OTM calls cheaper IV) benefits call diagonals. Put skew (OTM puts expensive IV) is mixed for put diagonals. Analyze skew to optimize strike selection.