Options Strategy: Diagonal Spreads

I have had good results so far this year with long diagonal call spreads, which have been attractive due to high volatility, and profitable because the market has rallied strongly off the March lows. This strategy is less attractive right now because volatility has been declining and market direction is questionable. However, if there is a correction with increased volatility, diagonal spreads will be again be a good way to play for a bounce or rally.

Diagonal Spread Strategy

In effect, the strategy is similar to a covered call, except that a long call is substituted for the stock. Using options and especially LEAPS as a substitute for stock is attractive because it provides leverage. The sale of a shorter expiration, higher time value call reduces or eliminates the time cost of maintaining the position, and will sometimes provide a favorable rate of return even if the stock only stays the same. Leverage magnifies losses as well as gains, so risk and volatility are both increased.

As an example, on 1/7 the following position was opened when Seagate (STX) was trading at 5.48:

Buy to open 10 YTDAZ, STX Jan10 2.5 Calls @ 3.20	(3,200)
Sell to open 10 STXFU, STX Jun09 7.5 Calls @ .65	650
Net Cost	(2,550)

My thinking is summarized in the table that follows: when looking at the time value of the long call I think of the time premium, 220 (10 X 100 X .22), as annualized interest on the additional money I would otherwise have spent to buy the shares, 2,500 in this case. I evaluate the time premium received on the short call as annualized interest or rental on the money spent on the long call. As shown, the effect is to “borrow” at a rate that is less than I receive for “lending.”

STX	Time value	As Interest/Rent %	Annualized
Long Jan10 2.5 call	.22	8.59%	.21
Short Jun09 7.5 call	.65	45.21%	1.45

Then I look at the possible outcomes as of the first expiration date:

06/20/09	Share Price	Jun09 7.5 call	Jan10 2.5 call	Gain/(Loss)	Annual return
$1 over short call strike	8.50	1.00	6.11	2.56	223.2%
Static	5.48	0.00	3.09	0.54	46.9%
Break-even	4.94	0.00	2.55	0.00	0.00%

Looking at possible outcomes on 6/20/09 when the short call expires, if the stock is above 7.50 at that time, the return will be 2,560 vs. a cost of 2,550, which is 223.2% annualized. If the stock goes nowhere, the annualized return is still 46.9% - the position makes money standing still. It would break-even with the stock around 4.94, about 16% below where it was at inception. Intuitively the position is appealing because the stock can only do three things: go up, go down, or stand still. The investor will make money on 2 out of 3 outcomes. You don't have to be right: all you have to do is not be wrong. Multiple trades are required and bid/ask slippage and commissions will reduce profits.

As the situation developed, Seagate (STX) got up over 8.50 and I closed the position on 5/4. Possibly I should have waited until the June expiration, when the profit would have been higher, but in this market it is good to take profits before they disappear. Here is the wrap-up:

Sell to close 10 YTDAZ STX Jan10 2.50 Calls @ 6.52	6,520
Buy to close 10 STXFU, STX Jun09 7.50 Calls @ 1.77	(1,770)
Net Proceeds	4,750
Net Cost	(2,550)
Profit – 270% annualized	2,200

What if? - how would a diagonal spread behave if the stock suddenly tanked? Fortunately, my recent experience on Dow Chemical (DOW) provides a good example.

11/17/2008	Buy to open 5 WDOAC, DOW Jan10 15 Calls @ 7.20	(3,600)
12/15/2008	Sell to open 5 DOWFE, DOW Jun09 25 Calls @ 1.15	575
	Net Cost	(3,025)
12/29/2008	Buy to close 5 DOWFE, DOW Jun09 25 Calls @ 0.35	(175)
1/27/2009	Sell to close 5 WDOAC, DOW Jan10 15 Calls @ 2.20	1,100
	Net Proceeds	925
	Loss – (208%) annualized	(2,100)

What happened was the K-Dow deal blew up and Dow was in trouble because they needed the money to safely close the Rohm and Haas acquisition. The stock tanked.

Dow was at 20.66 when I made the opening trade and 13.19 when I closed the position. If I had bought and sold 500 shares, the loss would have been (3,735). The loss was smaller in dollars using options than it would have been by trading the shares, although it was larger as a percentage of the money used. On the plus side, the stock was well under the strike on the Jan10 15 call when the position was closed, but the high volatility and length of time remaining to expiration created a time value of 2.20, illustrating a difference between calls and stock as far as downside risk.

Loss control on this strategy involves decisiveness in taking losses and moving on. I sometimes close both legs even though at that point the short call is unlikely to go into the money. The thinking is, getting whipsawed is nasty enough, why set yourself up to go through it in an effort to save a nickel on a way out of the money call?

Risk management involves an awareness that a portfolio with a large number of such positions will perform very poorly in a down market. Hedging with index puts can be helpful although it is expensive. Having longer dated expirations helps: because I was using mostly LEAPS which expire in January next year the market bottom in March was not too disruptive: I was able to hold the positions and wait for recovery.

Another thing that can happen is if there is bad news overnight the stock can be tanking in after hours or premarket trading but the options can't be traded until the market opens. I have had some success by short-selling the shares in the pre market, enough to neutralize the overall position, then I can analyze the news and close whichever side of the trade is indicated.

Volatility vs. directional trading – a digression here - a lot of books on options talk about various trades that are designed to benefit from changes in volatility. All that stuff about butterflies and condors and so on is a lot of fun but as a stock investor my interest is in gaining leverage or managing risk while investing in stocks where I have a directional opinion. Volatility is of concern for two reasons: 1) it increases the cost of buying options, so I try to find a way to sell enough options to keep time on my side. 2) high volatility is frequently a sign that a large move is imminent. So, when the premiums make the diagonal spread attractive, with a high static return, it's a good idea to be sure you have done your homework.

Disclosure: no current positions in the stocks mentioned.

Comments

[Orange Option:]

What about double diagonals?

May 16 10:49 AM

[H. T. Love:]

Great article for a n00b options/stock trader investor like me. I have a question.

Near the end of the article, you state you are a directional trader. If so, can one employ a strategy that opens the positions at different times?

E.g. for one of my retirement accounts, I sold calls while believing the stock would rise and fall several times before expiration, being a high volatility stock. In the past, I had garnered very good returns by selling the calls when the stock was near resistance, or an inflection point, and then closing the positions when the stock dropped to near support or another inflection point appeared imminent

May 16 11:53 AM

[H. T. Love:]

OOPS! Trying again.

Great article for a n00b options/stock trader investor like me. I have a question.

Near the end of the article, you state you are a directional trader. If so, can one employ a strategy that opens the positions at different times?

E.g. for one of my retirement accounts, I sold calls while believing the stock would rise and fall several times before expiration, being a high volatility stock. In the past, I had garnered very good returns by selling the calls when the stock was near resistance, or an inflection point, and then closing the positions when the stock dropped to near support or another inflection point appeared imminent. Made about 10% since 9/2008 while keeping the stock, which I wanted to do.

This time, I had a stock that I didn't mind if it got called away. Calls had been previously opened at the strike I wanted and I felt there was a good chance it it would be in the money on the June expiration. At May expiration, yesterday, the shorts had been doing their covering since Tuesday and continued to do it Friday through early afternoon. Having been watching the stock for a long time, I new the price would plummet when the shorts got exhausted.

I bought June puts at the lowest price for the day (good luck, but as I said I've been watching for a long time and know it *usual* behavior) and sold them back the same day for a 31.1% gain, all friction included.

Now, my question is this. Do you believe that if you have some confidence in the directional trend, and possibly are familiar with the behavior of the underlying, would it be a viable strategy to open positions such as I did at different times to gain the (hopefully) advantageous price on each leg?

Also, is shorting a call and going long a put, at the same or different prices "reasonable"? In my searches through the online literature and tutorials, I know I've read about this somewhere, but I couldn't find that one described after about an hour of searching yesterday. But I'm tenacious and will find it again.

Any risk management or enhancements you might suggest? My primary use so far has been covered calls and protective puts. The put saved my buns on Motorola last year - I exercised with a net loss of about $1.10. The covered calls have been used to generate income.

Thanks for your answers and the informative article.

HardToLove

May 16 11:55 AM

[TCK:]

Good discussion !

I have used a similar strategy myself. However, it seems that more income would be generated by always selling the front month call. Using the same example ; selling Jan, Feb. March, etc thru Jan 2010 provides the possibility to collect more premium.

Comments appreciated.

May 16 12:06 PM

[H. T. Love:]

P.S. My risk was reduced by the fact that most of the put purchase price was offset by the premium from the short call. I only paid net $.495 (friction included) for the puts I bought.

HardToLove

May 16 12:42 PM

[Tom Armistead:]

HardToLove, it makes a lot of sense to try to leg into your positions at an advantage. I do a fair amount of covered calls and frequently buy the stock and wait to sell the call until the stock has gone up some and I can get a decent premium by selling a call at or near my target price.

Short a call and long a put, if both have the same strike and expiration date, is a synthetic short position, equivalent to selling the stock. If you own stock and sell covered calls and buy protective puts with different strikes most authors would describe that as a collar, a defensive strategy. Either strategy is reasonable.

Trading in and out of covered calls would logically seem to incur a lot of commissions and slippage compared to waiting for them to expire, but my experience leaves me with the impression that if an options position shows a quick profit and a decent annualized rate of return often it is better to take the profit while you have it.

May 16 12:56 PM

[H. T. Love:]

On May 16 12:56 PM Tom Armistead wrote:

> HardToLove, it makes a lot of sense to try to leg into your positions
> at an advantage. I do a fair amount of covered calls and frequently
> buy the stock and wait to sell the call until the stock has gone
> up some and I can get a decent premium by selling a call at or near
> my target price.

That's what I decided to do. I've done only a couple of buy/writes and thought "Hmm, I can make more if I wait and I have correctly predicted the trend".

>
> Short a call and long a put, if both have the same strike and expiration
> date, is a synthetic short position, equivalent to selling the stock.

Aha! I was looking for more common thingy's like "straddle", "strangle", etc. I had forgotten all about the "synthetic". Of course, as soon as you said it, ... ;-)

> If you own stock and sell covered calls and buy protective puts with
> different strikes most authors would describe that as a collar, a
> defensive strategy. Either strategy is reasonable.

Good to know. My wife's account is authorized for such and she is very hard to live with if I lose much in her account! :-(

>
> Trading in and out of covered calls would logically seem to incur
> a lot of commissions and slippage compared to waiting for them to
> expire, but my experience leaves me with the impression that if an
> options position shows a quick profit and a decent annualized rate
> of return often it is better to take the profit while you have it.

That was the strategy I had developed, especially because I started all this trading in late 2007. Volatility was quite high and I felt I couldn't rely on any trend holding for a long duration. Recently I've begun to see a little more stability, although I'm really expecting some "corrections", at best.

Being with ETrade, my trade is only $7.99 (frequent trader) and $.75/contract. By doing 2 or more contracts per trade, the friction is fairly low. I don't do it often, but if I do two legs (complex option?) at the same time, the per-trade friction gets halved.

The stock I do most of the "in-and-out-in-a-day" will move (usually) a minimum of $1.80 and as much as $5 in a day. Most of the time, I've normally closed if I made $75/contract or more. If I saw a pattern that breaks the norm, I've made more. With premiums in the $2-$4 range, I felt the return was acceptable for a new guy like myself.

I really appreciate you taking the time. Not all are so generous. I look forward to more of your posts and have added myself as a "follower".

Best wishes,
HardToLove

May 16 01:57 PM

[Tom Armistead:]

TCK, good question, a book I studied when I got interested in options said for covered calls to use something like 90 days or more ahead to get adequate premium so I have just been setting things up along those lines.

I applied the same method of analysis as in the article to selling the same strike in different months, using STX Jun, Sep, Dec and Jan were available, Sep gave the best % return, plus you avoid repetitious commissions and bid/ask slippage.


On May 16 12:06 PM TCK wrote:

> Good discussion !
>
> I have used a similar strategy myself. However, it seems that more
> income would be generated by always selling the front month call.
> Using the same example ; selling Jan, Feb. March, etc thru Jan 2010
> provides the possibility to collect more premium.
>
> Comments appreciated.
>

May 16 02:59 PM

[Tom Armistead:]

Orange, I don't have any experience with the strategy, as a matter of fact I had to look it up on-line to learn how it works. You could describe it as a short strangle in a near month bracketed by a long strangle in a more distant month. It looks for the underlying to trade in a range, between the strikes, while the bull diagonal call spread is looking for a move upward for the best return.

The articles I located cautioned about doing the double diagonal when near term implied volatility is high, because that would be a sign that a large move is imminent. So, if you were considering such a strategy and the volatility was too high, you could check to see if you could develop a directional opinion and then bet on which way it would move.

On May 16 10:49 AM Orange Option wrote:

> What about double diagonals?

May 16 03:13 PM

[Missing_Link:]

Thanks, Mr. Armistead! I learned a lot from this article.

May 16 07:26 PM

[Ricard:]

Hmmm...I've stuck to basic strategies so far, no spreads or strangles. I'm afraid the commissions may get a bit out of control.

Something I've noticed with options is that your fees also experience some leveraged...:/

That being said, what is your take on writing covered calls in today's market (if you already own the stock)?

May 16 10:14 PM

[Tom Armistead:]

Today's market - we have come awfully far awfully fast. I have gone to 25% cash and sold covered calls where I could get good premiums at a strike and expiration that was somewhere along the trajectory to my one year targets for the stocks involved.

Homebuilders and building supply I sold ATM or OTM covered calls over almost everything I own because I think they have been ahead of themselves.

Tech I own mostly smaller more volatile types - I sold a small amount of OTM calls but this area could do extremely well and I hate to give away the topside at some future date. Going to cash I sold a lot of them for quick short-term gains. I would rather have dry powder than tie up my assets in order to give someone a good buy on the calls.

Energy and chemicals I have a few concentrated positions, I didn't sell any calls because I consider the stocks involved to be seriously undervalued. Going to cash I sold some of them at a small gain/(loss): thinking I preferred dry powder.

May 17 06:40 AM

[Ricard:]

Thanks for your two cents. I feel the same way you do regarding today's market in general, and small tech names in particular.

I went into this market thinking that selling covered calls would be a good hedge, and while they were generally good from November to December, subsequent efforts limited some of my gains. I've been lucky to close out losing positions quickly, which may have otherwise shut me out from the recent recovery.

I've decided on the same course of action on my emerging market stocks that you've taken on energy and chemicals, even down to the partial selling.

May 17 10:57 AM