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Managing A Diagonal Call Spread

This is an old trade that illustrates why diagonal spreads can be profitable for long term trades, as a substitute for owning the shares. The format is, the long, deep in the money calls are presented separately from the short, out of the money calls, to illustrate the purpose and profitability of rolling.

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At the time, the company had considerable cash to support the price at the low end, and between that and the volatility it was a good prospect for this type of trade.

The point is, that simply by rolling back and forth between the 2.5 and 5.0 strikes on the long leg, the premiums received for rolling up, and occasionally out, exceeded the premiums paid to roll down. In effect, I was able to get a non-recourse, notional loan of $2,500 or $5,000, it varied, to invest in owning the shares. Or more accurately, in controlling them. I was paid $501.12 to leave my money on the table.

There was also income from selling the covered calls, it totalled $275.63. Eventually the stock went through the strike, but that was good news, since the lower leg had a fine profit of $1,116 from the directional move when I closed it. The whole trade had an IRR of 37.53%, over a period of over a year and a half, compared to 13.78% that could have been realized buying and holding the shares over the same time span.

This works because volatility has a tendancy to increase when the shares decline, and the time value for an option that is close to the money is higher than one that is deep in the money. When the stock goes down far enough, roll down. After it recovers, roll back up. The premiums paid for rolling down from 5.0 to 2.5 were less than the premiums received rolling up and out from 2.5 to 5.0 and forward 6 months in two cases.

This was kind of a laboratory case, to see how long I could continue the process. I gave it up when the stock went over $7.50 on a run that finally took it over $10.00.

The stock has been back to the $5-6 area, and I'm working on getting this trade going again.

Disclosure: I am long HLIT.

Additional disclosure: Current positions are long HLIT 2.5 calls and short HLIT 5.0 calls.