Options Strategy: Diagonal Spreads

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 |  Includes: DOW, STX
by: Tom Armistead

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 (NASDAQ: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)

Click to enlarge

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

Click to enlarge

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%

Click to enlarge

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

Click to enlarge

What if? - how would a diagonal spread behave if the stock suddenly tanked? Fortunately, my recent experience on Dow Chemical (NYSE: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)

Click to enlarge


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.