Horizontal and Diagonal Spread Construction

Horizontal (calendar) spreads and diagonal spreads use options with different expiration dates. These strategies profit primarily from time decay differentials and volatility changes rather than directional price moves, making them distinct from vertical spreads.

Definition and Key Concepts

Calendar Spreads (Horizontal Spreads)

A calendar spread (also called a time spread) combines:

• Short option at a near-term expiration
• Long option at a later expiration
• Same strike price for both legs

The near-term option decays faster than the longer-term option, creating profit potential as time passes.

Diagonal Spreads

A diagonal spread combines elements of vertical and calendar spreads:

• Short option at a near-term expiration
• Long option at a later expiration
• Different strike prices for each leg

Diagonals offer directional bias plus time decay benefits.

Strategy Comparison

How It Works in Practice

Calendar Spread Construction

Example: XYZ trades at $50. You expect the stock to stay near $50 for the next month.

Trade:

• Sell 1 XYZ $50 call, 30 days to expiration, at $2.00
• Buy 1 XYZ $50 call, 60 days to expiration, at $3.25
• Net debit: $1.25 ($125 per contract)

Greeks Profile:

Key Observations:

• Net delta near zero (neutral position)
• Positive theta (earns time decay)
• Positive vega (benefits from IV increase)

Profit Zone: Maximum profit occurs when XYZ is at $50 at the near-term expiration. The short call expires worthless while the long call retains time value.

Diagonal Spread Construction

Example: ABC trades at $75. You're moderately bullish and want income.

Trade:

• Sell 1 ABC $77.50 call, 30 days to expiration, at $2.25
• Buy 1 ABC $75 call, 60 days to expiration, at $4.50
• Net debit: $2.25 ($225 per contract)

Greeks Profile:

Key Observations:

• Positive delta (bullish bias)
• Positive theta (earns time decay)
• Similar to covered call but using LEAPS or longer-dated options instead of stock

Worked Example

Calendar Spread Before Earnings

DEF reports earnings in 45 days. You expect implied volatility to rise leading up to earnings and want to capture that increase.

Current Situation:

• DEF at $100
• 30-day IV: 28%
• 60-day IV: 30%

Trade:

• Sell 1 DEF $100 call, 30 days to expiration, at $4.00
• Buy 1 DEF $100 call, 60 days to expiration, at $5.75
• Net debit: $1.75 ($175 per contract)

Position Analysis:

Scenario 1: Stock flat at $100, IV rises to 35%

• Short call at expiration: $0 (expires worthless)
• Long call gains from IV increase: approximately +$0.50 from vega
• Long call loses from theta: approximately -$1.20 over 30 days
• Long call at 30 DTE with higher IV: ~$5.00
• Profit: $5.00 - $1.75 = $3.25 × 100 = $325

Scenario 2: Stock rallies to $108

• Short call at expiration: -$8.00 intrinsic
• Long call with 30 DTE at $108: ~$10.00
• Net spread value: $10.00 - $8.00 = $2.00
• Profit: $2.00 - $1.75 = $0.25 × 100 = $25

Scenario 3: Stock drops to $92

• Short call expires worthless: $0
• Long call with 30 DTE at $92: ~$2.50
• Spread value: $2.50
• Profit: $2.50 - $1.75 = $0.75 × 100 = $75

The calendar spread profits in multiple scenarios because time decay works faster on the short leg.

Risks, Limitations, and Tradeoffs

Early Assignment Risk

The short option may be assigned before expiration, especially if:

• The option is deep ITM
• A dividend is approaching (for calls)
• Time value is minimal

Assignment creates a stock position that must be managed.

Volatility Sensitivity

Calendar spreads are long vega—they benefit from rising IV but suffer when IV declines. If you enter when IV is elevated and it drops, the long option loses more value than expected.

Pin Risk at Front-Month Expiration

Maximum profit occurs when the underlying is exactly at the strike at front-month expiration. Even small moves away from the strike reduce profitability.

Capital Efficiency

The long option ties up capital until the back-month expires. Rolling the short option can generate additional income but adds complexity.

Common Pitfalls

1. Ignoring vega exposure: Calendar spreads are volatility plays. Don't enter when IV is elevated unless you expect further increases.

2. Holding through both expirations: Most calendar profits are captured at front-month expiration. Consider closing or rolling then.

3. Choosing strikes too far from current price: OTM calendars have lower probability of maximum profit.

4. Not planning for assignment: Know what to do if your short call is exercised early.

5. Overleveraging: Calendar spread margins can be lower than the risk suggests in volatile markets.

Checklist for Calendar and Diagonal Spreads

• Identify expected trading range for the underlying
• Compare front-month and back-month implied volatilities
• Calculate net debit and maximum theoretical profit
• Assess vega exposure and volatility expectations
• Verify positive net theta (earning time decay)
• Check for upcoming dividends that might trigger early assignment
• Plan exit strategy at front-month expiration
• Consider rolling short option to generate additional premium

Next Steps

For multi-leg strategies with defined risk at multiple strikes, see Iron Condors, Butterflies, and Variations. These structures profit from range-bound price action.

For more on vertical spread mechanics, review Vertical Spreads: Bull and Bear Structures.