Calendar and Diagonal spreads are multi-legged options strategies that allow investors to gain exposure to the underlying security while limiting their risk. Spreads allow for a better risk/reward trade instead of buying and selling a single option, but also limit the maximum reward. Debit and Credit spreads are popular spread strategies where the investor would buy or sell a further OTM option that reduces either the cost or the maximum risk while limiting the unlimited profit potential one would receive when buying a single leg option. Calendar and Diagonal spreads work in a similar way but instead of buying and selling options with the same expiration date, different expiration dates are used. 

Consider the example of stock $XYZ trading at $130. The 6 month $100 call option currently costs $13. Buying this call option means the maximum risk of this trade would be $13 while the maximum reward is unlimited. For this strategy to be profitable, $XYZ would need to move above $143 ( a significant move). The problem with this strategy is that $XYZ needs a significant move to become profitable and that the cost of this trade is relatively expensive. Spreads provide an opportunity to reduce the cost and breakeven and lower the risk of an options trade. 

Call Calendar Spreads

A long call calendar spread is a short term neutral, long term bullish strategy where the investor buys a longer dated option while selling a shorter dated option with the same strike price. The longer dated option provides bullish exposure while the short leg reduces the initial cost and breakeven of the long leg. Once the short leg approaches expiration, it is generally rolled and more premium is collected which reduces the cost basis of the trade once again. 

Example - Stock $XYZ is trading at $130

Long Call Calendar Spread:

• Buy 6 month $130 call option @ $13 debit
• Sell 1 month $130 call option @ $7 credit
• The net cost of this trade and maximum risk is now $6

In this example, the investor still has a long term bullish outlook on $XYZ but is selling shorter dated options to reduce the cost of the long leg. At the expiration of the short leg (1 month), the spread will have a maximum value at $130. The short call becomes worthless approaching expiration due to theta eroding the option's value and the investor can keep all the premium (or buy to close/roll for a fraction of the original premium received) while the 6 month option (now 5 month) only deteriorates by a small amount. In this case, the investor is gaining a profit due to theta eroding the shorter dated option at a much faster rate than the longer dated option (assuming $XYZ stays at $130).

Call Diagonal Spreads

A long call diagonal spread is similar to a call calendar spread, but in this case, the investor sells an OTM call option instead of selling an ATM call option. The long ATM call will still provide long-term bullish exposure while the shorter dated OTM call reduces the cost of the trade. However, selling an OTM call option will receive less premium than selling an ATM call and result in a higher cost compared to the calendar spread, but provides better protection for the short leg if the stock makes an immediate bullish move. Consider a similar example to the one above.

Example - Stock $XYZ is trading at $130

Long Call Diagonal Spread:

• Buy 6 month $130 call option @ $13 debit
• Sell 1 month $150 call option @ $4 credit
• The net cost of this trade and maximum risk is now $9

Looking at the graph below, the maximum value of the spread has shifted to the right because the short leg's strike of $150 can still expire worthless after a small initial rally. If $XYZ has a major rally, unlike calendar spreads, diagonal spreads will still remain profitable. The general rule of thumb is that if the debit paid is less than the width of the spread, no losses would be incurred on a big rally.

Optimal Calendar Spread

• Long Leg: 90-180 days to expiration and 50 delta call/put
• Short Leg: 30-60 days to expiration and 50 delta call/put

The long leg can be further out than 90-180 days to expiration, but the further the expiration, the more expensive the option will be. For the short leg, 30-60 days to expiry is considered optimal as this maximizes the theta acceleration deteriorating the value of the option at a faster rate. Options shorter than 30 days will have higher gamma risk which will work against the trade. This strategy is best suited when short dated volatility is greater than longer dated volatility. This minimizes the cost of the long leg and increases the premium received for the short leg. This strategy is suitable for earnings with a neutral outlook. The short leg will experience a larger volatility crush after earnings than the long leg which will generally experience less of a volatility crush. 

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Optimal Diagonal Spread

• Long Leg: 90-180 days to expiration and 50 delta call/put
• Short Leg: 30-60 days to expiration and 20-30 delta call/put

Like calendar spreads, diagonal spreads are also best suited when shorter dated volatility is greater than longer dated volatility. However, unlike calendar spreads, when used as an earnings play, this strategy is better suited for a mildly bullish/bearish directional view. 

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Spreads Best Practices

These best practices are only applicable if you maintain your longer term neutral/mildly bullish/mildly bearish view

• Roll your short leg within 1-2 weeks of expiration
• Sell a new call/put based on 30-60 days to expiration and 20-50 delta call/put
• Continue to lower the cost of the long leg

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