Marrying the Diagonal Call Spread with the Wheel Strategy

What happens when you combine two of the most popular income strategies into one smart hybrid setup?

The Wheel Strategy involves a cyclical process of selling cash-secured puts and then selling covered calls to collect premiums at each stage of the process. On the other hand, the Diagonal Call Spread is a strategy where traders buy and sell options contracts with different strike prices and expiration dates, aiming to profit from changes in the underlying asset and time decay.

Taking elements and concepts from these two options trading strategies can lead to a more customized approach to options trading, where investors can enjoy consistent premium income with lower capital risk and better management of assignment. Our article will detail everything you need to know about the Diagonal Call Spread and the Wheel Strategy, and how they can be combined for a flexible and robust options trading strategy.

Quick Recap—The Wheel Strategy

The Wheel Strategy refers to a trading approach that focuses on selling puts or call options to generate income. It’s a cyclical approach to trading options where you would sell cash-secured put options and then sell covered calls on the shares if they are assigned. The reason the wheel strategy is cyclical is that it aims to generate repeat income from option premiums, with the promise of possibly owning the underlying asset someday.

Simply put, the Wheel Strategy involves a process where the trader sells cash-secured puts, gets assigned if the stock price falls below the strike price, sells covered calls on the assigned shares, and then collects premiums from those covered calls. Along the way, traders can pick up stocks they feel bullish about at a discounted price, rather than buying them outright.

Benefits

• Premium Income—The primary driver behind the profitability of this trading strategy is that traders can collect income from the option’s premiums. There is a cyclical process in place where traders can sell cash-secured puts, get assigned shares, and then sell covered calls on those shares to generate consistent income from their holdings.
• Potential to Own Shares at a Discount—The wheel strategy does come with an assignment risk, but it allows traders to own shares of a stock they don’t mind owning and enjoy a considerable discount.

Drawbacks

• Requires More Capital—The wheel strategy involves cash-secured puts, which means that the trader must set aside the money to potentially cover 100 shares of the underlying stock at the strike price if the option is assigned. This involves a significant capital requirement on the part of the trade, depending on the current price of the stock.
• Exposed to Downside Risk if the Stock Tanks—There’s the distinct possibility that the stock could go way down in value, rendering the Wheel Strategy completely useless and leaving traders and investors exposed to downside risk. This makes it all the more relevant for traders to use stop losses when employing this strategy to protect themselves in the event of such a scenario.
• Limited Upside from Covered Calls—Compared to simply owning the stock, the covered call involved with the Wheel Strategy has limited upside potential, even with the possibility of income generation and the risk mitigation benefits that come along with it.

Quick Recap—Diagonal Call Spread

A diagonal call spread is a strategy where traders buy and sell options with different strike prices and expiration dates. It involves a combination of factors, including spreads such as vertical and calendar spreads. The diagonal call is made up of longer-dated calls and shorter-dated calls at a higher strike. The goal with this trade setup is to secure a profit due to changes in the underlying asset’s price and time decay.

Main Benefits

• Limited Capital Requirement—Diagonal spreads are sometimes called the “poor man’s covered call,” and this name is derived from the fact that the capital requirements to get into this trade are much lower compared to using other option strategies or owning the underlying asset outright. This might be the most significant benefit of the Diagonal Call Spread: the affordability that comes from using it along with the promise of cyclical premiums.
• Lower Assignment Risk—The short option of the diagonal spread is particularly susceptible to an early assignment risk. Still, it’s only relevant if the short option goes deep in-the-money. Overall, this makes for a strategy that has a generally lower likelihood of assignment. You see a greater risk associated with this factor when it comes to the Wheel Strategy, which we’ll delve into in more detail later.
• Time Decay Advantage (Theta)—Diagonal Call Spreads are designed to leverage time decay. The short-term call experiences faster time decay, which works in favor of the Diagonal approach, because the premium received from selling the option erodes more quickly over time.

On the other hand, the long-term call has more time to expiration, which results in slower time decay. The benefit of the faster decay from the short-term call can offset the cost of the long-term call, enhancing the profitability of the spread.

Common Use

Diagonal spreads are best suited for directional income trades, in addition to the other benefits we outlined above. Traders can structure their spreads to be either bullish or bearish, which means that they can secure a profit if the price of the underlying asset moves in the direction they structured the trade around.

Why Marry the Two?

What is the sense of combining the Wheel Strategy with the Diagonal Call Spread? After all, there is much more active management required when using these two approaches in conjunction with one another, such as keeping a closer eye on the Greeks and striking a delicate balance between timing and directional bias.

• Limit Capital Outlay—Pursuing the Wheel Strategy on its own can be a significant undertaking, requiring the saving of money for potential assignments. However, combining the Wheel with Diagonal Call Spreads can cyclically produce steady premium income, keeping money flowing in and potentially covering those assignments. You’re keeping the core logic of the Wheel, but you don’t have to have the money saved up because the premium income from the call spreads can take care of that.
• Avoid Assignment While Collecting Weekly/Monthly Income—Joining forces with these two strategies can help traders avoid assignment by rolling short put assignments to a later expiration date or a higher strike price. At the same time, traders can enjoy premium income collection from the Diagonal half of the strategy to cover any possible assignments that come up where it could not be adequately adjusted ahead of time.
• Gain Flexibility in Trend Bias—Using the long Diagonal Call Spread (the Poor Man’s Covered Call) along with elements from the Wheel Strategy can allow traders the flexibility they need to take advantage of different trend biases that might come up in the markets.
• Avoid Full Stock Purchase—By integrating the Diagonal Call Spread into the Wheel Strategy, traders can avoid having to purchase the stock fully. However, this combination allows them to simulate covered call mechanics.

How the Combined Strategy Works (Step-by-Step Breakdown)

When you marry the Diagonal Call Spread with the Wheel Strategy, there are specific steps you must follow to ensure that both strategies are used for maximum effect. Below, we have included a step-by-step breakdown of this process to provide you with an idea of where to start and how to guide both strategies to profitability.

Step #1—Sell Cash-Secured Put (Wheel)

The first step to implementing this strategy is to sell cash-secured puts and either wait for potential assignment or roll to a further expiration or a higher strike price to capitalize on premium income. What you don’t want to do in this step of the trade setup is buy the 100 shares of the stock outright. If it goes to assignment, you have no choice but to purchase the shares, but in the context of this combined strategy, you want to hold off.

Step #2—Enter Diagonal Call Spread Instead of Buying 100 Shares

If the stocks that you’re selling the cash-secured puts on are bullish and not assigned, the next step is to begin a diagonal call spread instead of buying the 100 shares outright. Consider purchasing a two- to three-month at-the-money or in-the-money call while also selling a one- to two-week out-of-the-money call. This approach simulates a covered call for the trader, but it requires a lower capital outlay and involves less risk than buying 100 shares.

Step #3—Repeat Short Call Selling (Like the Wheel)

The next step involves rolling these positions weekly for theta decay income through repeat short call selling. This component of the trade allows traders to sell calls, capitalizing on theta decay repeatedly. When the short-term call expires worthless, traders can keep the premium received while also repeating the process by selling additional short-term calls against the long-term position. Over time, this move can generate continuous income and reduce the cost basis for the long call.

Step #4—Manage or Exit the Long Call

How you proceed with the trade primarily depends on your specific trading goals and personal risk tolerance. One of the best moves to make when using the Wheel Strategy alongside the Diagonal Call Spread is to use the long call to hedge against potential losses from short puts.

If you’re looking for a good reason to exit the long call, there are several scenarios where it can be the appropriate move in the grand scheme of the total strategy. If the long call has appreciated considerably, the trader can exit the long call as long as they are satisfied with the profit they have generated. The long call could also be sold if the short call is nearing expiration and the stock prices are below the strike price. This allows the traders to realize a profit from the total spread.

Example Trade Setup

Let’s take a look at a hypothetical trade to run through what a partnership between these two strategies might look like using some hypothetical stocks and numbers. Combine this example trade setup with the step-by-step guide above to get a deeper understanding of how you can leverage the power of a Diagonal Call Spread with the Wheel Strategy.

Underlying: XYZ trading at $45

Steps to Using Both Strategies

• Step 1: Sell 45 puts for $1.20
• Step 2: Not assigned → Buy 60-day 45 call @ $3.50
• Step 3: Sell weekly 47 call for $0.80

Pros & Cons of the Combined Approach

When using this combined approach to maximize your premium income potential, there are several other benefits that come with the process. However, you should also be aware of some potential downsides that should be known upfront before implementing this strategy. For your convenience, we have outlined the primary pros and cons of using the combined approach, which can provide a clear and comprehensive understanding of the advantages and disadvantages of pursuing this strategy.

Pros

• Lower Capital Requirement—Traders interested in doing the complete Wheel Strategy will find that the capital requirement is a lot higher than it would be combining the Wheel Strategy with the Diagonal Call Spread. The Wheel Strategy requires the trader to save enough money to potentially purchase 100 shares of the underlying in the event that the contract is assigned. The appeal of combining the two strategies lies in the lower capital commitment required by the investor.
• Higher ROI Potential—Combining the two strategies focuses on enhancing the premium collection through a cyclical process of buying and selling calls, while also presenting the possibility of picking up bullish stocks at a discounted price. Overall, using the two strategies in conjunction with one another generally yields a higher ROI compared to using each strategy in isolation.
• Better Use of Time Decay via Diagonal Spreads—Combining the two strategies can enhance the potential profitability. This is especially the case when the diagonal spread can be used to properly manage stock positions that are acquired at a discount through the Wheel Strategy.
• Avoids Forced Assignments and Holding Shares—Combining these two strategies offers traders the flexibility to adjust their positions in a way that allows them to avoid forced assignments. It can’t always be done in every scenario, but it offers traders the option to manage their positions in a way that gives them some flexibility. In the worst-case scenario, the trader can pick up some good stocks at a discounted price.

Cons

• More Complex Management—This combination will inherently be more involved than using either of the trading strategies alone. There is more active management involved when pairing the Diagonal Call Spread with the Wheel Strategy. On top of managing the continuing cycle of buying and selling call options for premium collection with the Diagonal Call Spread, you’re also having to juggle investments with the Wheel Strategy, where you must save enough money to cover possible assignments.
• Must Monitor Greeks—Along with a more active management approach, marrying the Diagonal Call Spread with the Wheel Strategy requires a more active monitoring of the Greek symbols, especially theta and delta. This can be a lot for some traders to deal with on top of the other elements of management that come with using these strategies in partnership with one another.
• Requires Directional Bias and Timing—Diagonal Call Spreads require a bullish or moderately bullish bias, while the Wheel Strategy has a more neutral to slightly bullish approach. In addition to the different direction biases, traders must also effectively balance these dynamics with good timing.

Best Market Conditions for This Strategy

When is it best to combine elements of the Diagonal Call Spread and the Wheel Strategy for maximum impact? Identify the ideal market conditions necessary to execute a combination of these strategies successfully. We have found that there are four primary market conditions where using these two trading techniques in partnership is super advantageous.

Mildly Bullish to Neutral Markets

The Diagonal Call Spread does best when the underlying asset’s price increases gradually over time. The Wheel Strategy also does well in these conditions, especially when the trader is using a covered call. When it comes to neutral markets, the Diagonal Call Spread can generate income in sideways or neutral markets, allowing traders to secure premiums from both call and put options. Diagonal Call Spreads also do well with neutral markets and can profit with sideways action if the strikes are planned close to the current price.

Lower Volatility Environments

This pairing performs well when market conditions are characterized by low volatility. This move is notable for being ideal for long call entry. Traders would begin by buying a long-term call option and selling short-term call options with a higher strike price. The short leg should have strikes closer together to take advantage of the low volatility conditions. Likewise, the long leg of the Diagonal Call Spread should utilize longer-term options to capitalize on the low volatility levels.

Marrying this move to the Wheel Strategy comes into play when the short call is exercised and the trader is assigned the shares. Traders can transition the Diagonal Call Spread into the Wheel Strategy by selling covered calls against the shares they may have acquired during the assignment. It’s a smart move that helps traders to continue collecting premium income even though they were assigned to buy the shares.

Ideal for High IV Rank Stocks

When IV rank is high, it’s the perfect environment for enjoying higher option premiums, which makes selling shorter-term calls in a Diagonal Call Spread favorable. Traders can capture a higher premium in these environments, which can lead to significant income generation. The high IV rank stocks, in this case, experience enhanced premiums, especially when you’re dealing with short calls.

Not only can the trader take advantage of the high IV by selling the short-term, but they can also combine the trade with the Wheel Strategy because they’d be dealing with cash-secured puts and covered calls, which benefit significantly from higher IV. Plus, the Wheel Strategy, paired with the Diagonal Call Spread, offers opportunities for traders to possibly pick up stock they wouldn’t mind owning outright at a discount.

Possibly Owning Stocks You’re Trading Synthetically

To begin using the Wheel Strategy, you would choose stocks that you’re feeling bullish about, but ones that you wouldn’t mind owning if there were a situation where you were obligated to buy them. Then use a Diagonal Call Spread where you’re using it in lieu of directly purchasing the shares outright. This strategy allows you to collect a premium by selling the short-term call. At the same time, you maintain bullish exposure to the stock through the long-term call. This lets traders take advantage of upward movement potential.

Risk Management Tips

How can you effectively manage the risks that come with the Wheel Strategy and the Diagonal Call Spread? Continue reading, and we will offer some tips and best practices for keeping losses to a minimum and the exposure levels healthy with each of these option trading strategies.

• Define Profit Targets and Exit Points for Each Leg—Dealing with the risks associated with the Diagonal Call Spread and the Wheel Strategy starts with a sound trading plan where investors already have an idea mapped out of how much profit they’re willing to take on the trade as well as how much they are comfortable with losing. It is generally best to begin using these strategies with a clear idea of entry and exit points for each leg of the trade, as well as pre-established profit targets.
• Roll Short Calls Before They Go ITM—To avoid early assignment, traders can roll short calls to prevent them from going in-the-money. It can be accomplished in several ways. Rolling up involves buying back existing short calls and selling a new call at a higher strike price, which puts the new strike further out-of-the-money. Rolling out consists of buying back your existing short call and selling a new call with the same price but a different expiration date, which gives the stock more time to have its price move down.
• Don’t Let Long Call Go to Zero—No matter what form of trading you’re engaged in, you’ll want to either take profit or cut losses early to keep from sinking into further losses or not capitalizing on profit when it is at an all-time high. No matter what, it’s key not to let your long call go to zero, especially in the case of partnering the Wheel Strategy with the Diagonal Call Spread.
• Consider Using Stops or Alerts—Use these tools to manage directional risk properly. When prices initially begin to drop, alerts can help traders keep a closer eye on these investments, allowing them to either exit early or monitor their progress. Stops can help limit losses to a point where traders are comfortable with the level of loss.

Final Thoughts

When using the Wheel Strategy in conjunction with the Diagonal Call Spread, this interesting hybrid strategy combines flexibility, income, and more innovative capital utilization. Each technique offers its benefits, but the combined approach promises additional premium income and more efficient use of resources. Instead of saving up money to cover a potential assignment as a part of the Wheel Strategy, the combination strategy allows for enough premium income to cover the expense.

To combine the best elements of these two different strategies effectively, it is best suited for active traders who are comfortable managing spreads and can stay on top of the active management required to oversee the various elements of this setup. To any traders who find themselves in between, not quite new but also starting to incorporate active management into their investments, we encourage you to paper trade it first with real capital to get a feel for how this strategy works.

Final Take: Two Strategies, One Powerful Income Engine

Now that we have walked you through integrating the Diagonal Call Spread into the Wheel Strategy, is this the next evolution of the Wheel Strategy?

Only time will tell as more traders begin using this technique and reap the benefits of increased flexibility, higher premium income, and smarter capital utilization. For the time being, we believe it’s safe to say that this could be the most effective way to implement the Wheel Strategy without owning the stock shares outright. With this in mind, continue to use responsible practices when experimenting with this hybrid model. Utilize small positions, paper trading simulators, backtesting, and journal tracking to your advantage for optimal results.

Want help executing this? Check out our Options Strategy Builder tool!