A few months ago, I wrote an article about selling puts to gain assignment to shares of Coca-Cola (NYSE:KO), as I believe the future prospects are bright. That trade is still very much intact, but below I have outlined an additional options trade that will allow one to benefit from an upward move without the unexpected possibility of being assigned.
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Coca-Cola has excellent growth and a steady dividend, thus making it attractive to many long-term investors. However, while this stock fits nicely in someone's long-term account, that doesn't mean others can't enjoy a nice ride as well.
While I encourage holding KO long term because I believe in the great prospects, as highlighted in an article from earlier this year, I thought shares would be fairly valued near $36. But I do look for the short- and intermediate-term trades that are presented to us on a daily basis by the market, and I think we have one now. Below is the trade I plan to implement on KO.
- Buy 1 May 35 call at 2.15
- Sell 1 December 37.5 call at .20
- Net Debit (Max Loss): 1.95 ($195)
This trade is known as a "diagonal spread trade," and one of the reasons that I like it so much is how cheap it really is. While at first glance it appears that this trade really isn't that cheap, it is when you consider several factors.
First, when you consider the price of the long option, the May 35 call, it trades with an intrinsic value of 1.16. This value is derived from the difference in strike price and the current price of the underlying stock, 36.16 - 35 = 1.16.
- Stock Price: $36.16
- (Less the strike price): 35.00
- Intrinsic value: 1.16
- Time value: .99 (found by subtracting the intrinsic value from the net debit)
The real beauty of it is how you can use multiple options strategies to benefit your current position. While the intrinsic value of the long call is $116, there is still a remaining $99 in time value. Since time value is worth no more that just that, time, we can look at different ways to reduce the overall price of it. The way we have decided to do this is by selling the December 37.50 call.
By selling the 37.50 call for a .20 credit, all of which is time value, it allows you to subtract that amount from which you paid for the long call, thus bringing the overall net debit to $195.
The short call, expiring in December is over $1.50 out of the money. In the event that KO fails to close above $37.50 by December expiration, you keep all .20 in collected premium. While this may seem like "chump change" at first, one can quickly see the benefit in repeating the process several times over.
Better yet, what if Coke does close above $37.50 by December expiration? While you might have to cover the short call at a potential loss, the long call that expires in May will have increased far in value, since it has a lower strike price of $35. Assuming the short call did not move into deep-in-the-money territory in such a short time frame, it will have suffered from heavy time decay in the final weeks of expiration.
The goal of properly using the diagonal spread is rather easy: Sell out-of-the-money call options to reduce the overall cost of the long, back-month call (in this case the May 35 call), while still leaving room for profit should the stock unexpectedly move violently upward.
This trade does not come without risk, however. As even many novice options traders know, options involve substantial risk as well as reward. The risk in this trade is simply the net debit, or $195. If by December Coke is still trading for $36.16, the short December call will have expired worthless, while the long May call will have decayed very little due to the longevity the May expiration provides.
Now should you continue to hold on to the long May 35 call, you could continue by selling the next call, or January expiration, and further reduce the overall cost basis by reducing the net debit. The selection of strike price will vary depending on the movement of the underlying stock. The beauty of diagonal spreading is that it has the benefits of both calendar spreads and vertical spreads. It allows one to reduce risk, have room for profit should the stock close above the short strike, and reduce the cost basis of the trade on a month-to-month basis.