240 Part II: Call Option Strategies 
by the underlying stock. If such a rally occurred, he could make unlimited profits on 
the long side. If it did not, he loses nothing. 
Example: Assume that the same spread was established as in the last example. Then, 
if XYZ is at or below 31 ½ at April expiration, the April 30 call can be purchased for 
1 ½ points or less. Since the call was originally sold for 3, this would represent a prof­
it of at least 1 ½ points on the April 30 call. This profit on the near-term option cov­
ers the entire cost of the July 35. Consequently, the strategist owns the July 35 for 
free. If XYZ never rallies above 35, he would make nothing from the overall trade. 
However, if XYZ were to rally above 35 after April expiration (but before July expi­
ration, of course), he could make potentially large profits. Thus, when one establish­
es a diagonal spread for a credit, there is always the potential that he could own a call 
for free. That is, the profits from the sale of the near-term call could equal or exceed 
the original cost of the long call. This is, of course, a desirable position to be in, for if 
the underlying stock should rally substantially after profits are realized on the short 
side, large profits could accrue. 
DIAGONAL BACKSPREADS 
In an analogous strategy, one might buy more than one longer-term call against the 
short-term call that is sold. Using the foregoing prices, one might sell the April 30 for 
3 points and buy 2 July 35's at 1 ½ points each. This would be an even money spread. 
. The credits equal the debits when the position is established. If the April 30 call 
expires worthless, which would happen if the stock was below 30 in April, the spread­
er would own 2 July 35 calls for free. Even if the April 30 does not expire totally 
worthless, but if some profit can be made on the sale of it, the July 35's will be owned 
at a reduced cost. In Chapter 13, when reverse spreads were discussed, the strategy 
in which one sells a call with a lower strike and then buys more calls at a higher strike 
was termed a reverse ratio spread, or backspread. The strategy just described is 
merely the diagonalizing of a backspread. This is a strategy that is favored by some 
professionals, because the short call reduces the risk of owning the longer-term calls 
if the underlying stock declines. Moreover, if the underlying stock advances, the pre­
ponderance of long calls with a longer maturity will certainly outdistance the losses 
on the written call. The worst situation that could result would be for the underlying 
stock to rise very slightly by near-term expiration. If this happened, it might be pos­
sible to lose money on both sides of the spread. This would have to be considered a 
rather low-probability event, though, and would still represent a limited loss, so it 
does not substantially offset the positive aspects of the strategy.