A diagonal spread is a long option and a short option of the same type that differ in both strike and expiration. Its best-known form runs a covered call without the shares. A covered call ties up $10,000 on a $100 stock to collect a dollar or two a month. Replace the shares with a long in-the-money call that expires months later, sell the same short-dated call against it, and the capital falls to a fraction. Traders call that the poor man's covered call.
From calendar to diagonal
Module 8 built the calendar spread: sell the front month, buy the back month at the same strike, long vega and paid by the front option's faster decay. A diagonal moves the strikes apart. Buy the back-month call at a lower strike and sell the front-month call at a higher one, and the position leans long: it wants the stock to rise, but only as far as the short strike by the front expiry.
The poor man's covered call
Push the long strike deep enough into the money and the back-month call behaves much like stock. Take a $100 stock at 30% volatility. Buy the 180-day $85 call for $18.71: its delta is 0.83, so it moves like 83 shares. Sell the 30-day $105 call for $1.66, delta 0.31. The net cost is $17.05 a share, $1,705 for the pair, against $10,000 for 100 shares. Many traders use a LEAPS call, a year or more from expiry, for the long leg.
P&L per contract on a $100 stock at 30% volatility, entered for a $17.05 debit. The dark line is the P&L when the front call expires, with the long call still worth its model price. Drag volatility down: even that line sinks, because the long call has five months left and is long vega. Drag days down to watch the green line grow into the tent near $105.
The chart shows P&L when the front call expires. Near $105 the position makes about $538: the short call expires worthless and the long call has gained. Above $105 the gain levels off and drifts lower, because the long call, with a delta under 1, gains a little less than the short call loses.
Below the entry the loss is capped at the $1,705 paid, where a covered call can lose close to $10,000. Against the capital, though, the loss comes much faster: a fall to $90 by the front expiry costs this position about $673, 39% of the money in it, while the covered call loses about $834, under 9% of its money. Less capital means leverage.
The width rule
Before trading, check that the gap between the strikes, $105 minus $85 = $20, is larger than the debit, $17.05. At the front expiry the short call is worth exactly the stock minus $105 and the long call at least the stock minus $85, so with the stock above $105 closing both legs brings in at least the $20 width. An early assignment works out the same: you deliver shares at $105 and can get them for $85 by exercising the long call, or do better by selling it. Here that leaves at least $2.95 a share; with the width below the debit, a rally you were right about would lose money. The longer the long call runs, the more of its price is time value and the harder the rule is to meet, which is why buyers of a year-long call go deeper, often to a delta near 0.80. Module 13 explained how assignment itself works.
Front against back: decay and vega
The income comes from the difference in decay. The short 30-day call loses about 5.4 cents a day and the long 180-day call about 2.2 cents, so the pair collects about 3.2 cents a day, $3.24 a contract. The front option decays faster because time decay is steepest near expiration.
Vega runs the other way. The long call has 0.175 of vega per vol point and the short call 0.10, so the position is long about 0.07. If implied volatility drops three points across every expiration, it loses about 20 cents a share with the stock unchanged, six days of decay gone. Selling front-month volatility and owning back-month volatility, it likes a front that is rich against the back, as Module 11 showed.
Net Greeks per share of the same position against the stock price. The days slider sets the front call's days left; the long call always has 150 more. Theta is positive near and above the $105 strike and negative well below it. Switch to vega: it stays positive at every price. Drag days down to 5 and watch theta near $105 jump.
Theta is positive from about $95 upward and peaks near the short strike. Below that, the short call is nearly worthless and the long call's own decay is all that remains, so the position pays theta instead of earning it. That is the diagonal's version of the wheel's downtrend problem: a falling stock leaves you holding a decaying long call with little to sell against it.
The maths: net debit, width and the net Greeks
For a long back-month call at strike K1 costing C1 and a short front-month call at a higher strike K2 paying C2: the net debit is D = C1 - C2, the trade needs K2 - K1 > D, and each net Greek is the long leg's minus the short leg's. In the example, D = 18.71 - 1.66 = $17.05 and the width leaves 20 - 17.05 = $2.95 of cushion. Delta is 0.83 - 0.31 = 0.52, so the pair moves like 52 shares, against 1 - 0.31 = 0.69 for the covered call. Theta is -0.022 - (-0.054) = +0.032 a day and vega 0.175 - 0.102 = +0.073 per vol point.
Why the long call behaves like stock: its delta is N(d1), with d1 = [ln(S/K) + (r + v²/2) T] / (v √T). For the $85 call with half a year left, ln(100/85) = 0.163, (0.04 + 0.045) × 0.493 = 0.042 and v√T = 0.30 × 0.702 = 0.211, so d1 = 0.205 / 0.211 = 0.97 and N(0.97) = 0.83. A deeper strike brings delta closer to 1 but ties up more capital.
Your turn
Open QQQ on the Options Chain. On the monthly expiration find the call with a delta nearest 0.25 and read its Mid and Theta: that is the call you sell. Then switch to the monthly expiration about two months out, find the in-the-money call at the strike nearest 95% of the stock price, and read its Mid and Vega. The difference in mids is your debit: check it against the width. The difference in vega is why this trade cares about volatility.