Several months ago, I decided to write an article (my first!) on diagonal spreads, which have recently become one of my favorite directional trading techniques. A quick search with the Seeking Alpha search tab revealed that the subject matter has already been covered extensively by Mr. Tom Armistead. I scrapped my plans at the time, but recently decided to pick it up, since I've noticed some differences between his trading style and mine. If you haven't read his article, I suggest you give it a try.
Now that I've closed several trades, I've decided to revisit the topic, and touch on some issues. For those of you who haven't read Mr. Armistead's article, and are unfamiliar with a diagonal spread, I will summarize. A diagonal spread is a combination of a calendar spread and a vertical spread - that is, a spread that takes a long position in one month, and a short position in another month at a different strike price.
A diagonal spread attempts to capture time decay without completely sacrificing directional speculation. In other words, the trade can benefit from a difference in the rate of time decay between a long position, which expires further out than the short position. In addition, the trade can benefit from a correct speculation in the direction of the underlying asset. Depending on how the trade is structured, one can profit even when the direction of the underlying asset goes opposite from what is expected, or at least mitigate a potential loss in total dollars.
Here's an example of one of my trades gone horribly wrong. I entered near the end of January, expecting Home Depot (HD) to slow its dramatic rise, or even to decline. I also began to feel that the market had run its course, so I expected at some point the market would assist my trade.
Home Depot Trade Activity
underlying stock price
Bought 1 HD Jan 18 2014 50.0 put
Sold 1 HD Feb 18 2012 44.0 put
sold 1 HD mar 17 2012 45.0 put
Feb 18 2012 44.0 put expired
bought 1 HD Mar 17 2012 45.0 put
sold 1 HD Mar 17 2012 47.0 put
sold 1 Apr 21 2012 47.0 put
bought 1 mar 17 2012 47.0 put
bought 1 Apr 21 2012 47.0 put
sold 1 HD Jan 18 2014 50.0 put
$94.99 or 8.9%
As the reader can see, I lost nearly $95, and more importantly, I lost 8.9% in less than 2 months. However, had I shorted the stock I would have lost $426, or 9.5%, and that's before transaction fees and interest. Had I played this with put options alone, I could have lost 100%. The truth is, I made mistakes in my assessment of the stock, in my assessment of the market, and in my trade executions. With all these mistakes, I still managed to lose less than I would have with other methods.
Mr. Armistead describes a trade structure using in the money LEAPs for the long portion of the trade, and out of the money short positions approximately 90 days out. I also prefer to open my trade with a long, deep in the money option. This position is essentially a synthetic long position if a call, and a synthetic short position, if a put.
First, I choose a long position. I am terrible about short term directional predictions. It seems that any position I pick tends to do the opposite of whatever I expect as soon as I plunk down money. Only over time do my theories tend to bear out. So, I tend to try to want as much time as possible in a trade to be proven right. Therefore, I usually open this position by choosing the farthest date available for my long position.
Next, I need to choose a strike price for the long position. The position should be deep in the money, at least 10% in the money from the stock's current price. The deeper the strike price, the less leverage and the safer the trade.
Choosing the proper strike price takes finesse. Most LEAP positions are going to have almost no volume. If one chooses the strike price purely for safety, he/she is going to pay in a reduction of leverage and most likely pay severely in slippage cost (bid/ask spreads for LEAP strikes can be up to several dollars apart). If one chooses the strike price for maximum leverage, risk is likely to be prohibitively high. The long position will no longer behave like the underlying asset, and the odds the position will soon be deep out of the money is very high. The trader must juggle needs for leverage, slippage reduction, and safety to come up with an acceptable long strike price.
The short call or put uses the long LEAP as collateral, much as owning the underlying position would for a covered call. Since I am trying to benefit both directionally and from time decay, I write out of the money calls (or puts) at the nearest month possible. By using the LEAP and the nearest expiration short position I maximize the time rate difference between the two positions.
Picking the short position is also an art rather than science. More profit will be made if you can successfully sell options on your LEAP without threat of execution for your short (provided the underlying asset doesn't promptly and sharply turn against you). However, you need to make enough premium on each short position you write to adequately compensate you for risk, and the time value your long position will lose.
I am usually happy with a 3% a month return. Depending how deep in the money your long position is, 3% a month should not be too difficult. Of course, you are unlikely to earn this overall, as you are bound to lose money on some of your trades.
I have found that this trade takes a good deal of involvement if one is to keep some modicum of safety. First, the very structure requires the trader to write positions every month. Furthermore, the position can quickly lose money, and, in that case, a trader needs to determine whether he/she will close the position, wait, or roll the short option down.
Of the three strategies, I recommend the first and the third. If one is no longer certain of their convictions, the trade should be closed immediately. Otherwise, rolling the short option down once it has lost much of its value can be a viable strategy. I prefer to roll down to the same the expiration date.
If the asset rises too rapidly, the trader will be facing a short position bound to exercise. I would prefer not to have the position exercise, because of the hassle involved. However, I want to close the position when the short has the least amount of time value. Therefore, if the short position is a put, I will wait until the last day to close the entire position.
If the short position is a call, I will close the position with a day or two left, depending how far in the money the position is. This plan must be altered if the underlying stock has an ex-dividend date anywhere near the expiration date. The call is likely to be exercised on the ex-dividend date, so I will close the position on that date. I seldom roll the position forward, since I've rarely been able to garner 3% monthly by doing so.
In short, this is not a perfect trade for everyone, and it is not a perfect trade for all circumstances. But if you are looking for a way to trade directionally, to leverage your returns, without plunking down very much cash to do so, a diagonal trade may work wonders for you. Below, I've summed up the strengths and weaknesses as I see them. Hopefully, readers will add their thoughts.
- Leverage. Less money risked than purchasing the underlying stock.
- Potential protection against mistakes in timing. Deep in the Money LEAPs can lose less money than other leveraged strategies, because of time value. Short out of the money positions will lose money faster, and the money made on them will compensate for some of a trader's overall losses.
- Leverage. Once the market price of the underlying asset approaches the long position's strike price, the volatility in this trade can become excessive.
- Slippage. Because the various positions one might want to take can be thinly traded (especially the LEAP portion of the trade), slippage becomes a major issue. I've seen situations where several dollars of spread exist between the bid and the ask price. To me, this is the greatest hazard with this trade.
- Limited profits. If you expect a quick move upwards or downwards, and are extremely confident in your assessment, this trade structure is probably not the way to go. If the stock moves very quickly, your short position will be in the money and your gains will be capped.
- Greater involvement is required than buy and hold strategies.
- Taxes. The great number of trades involved mean documentation pain, and short term capital gains.
In my next article, I will discuss several specific diagonal spreads I've recently closed, and the logic I used to develop them. Thank you for taking the time to read my article.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.