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Tom Armistead
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I am a retired accountant, having spent the early years of my career in the insurance industry and the later part in the field of accounting. My insurance experience has given me the willingness to accept investment risk if I feel the return justifies it; also, an interest in applying risk... More
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  • Managing A Diagonal Call Spread  1 comment
    Mar 7, 2012 6:01 PM

    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.

    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.

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  • Rookie IRA Investor
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    Yes, I have been using a similar strategy on NOK with some success. Another variation I have been experimenting with (similar idea, but reversed) is buying very deep out of the money puts in stocks I might like to own if they are cheap enough. These serve as a disaster hedge, but can also provide the long leg for future bull put spreads if the stock falls enough and volatility rises. As one example, last week I bought 20 January '13 $10 strike puts in ANR for 85 cents each. The stock has tanked as I suspected it might, and the bid price is now $1.05, so a nice little profit (big profit percentage wise) or a chance to convert to the $15/$10 bull put spread at a very nice discount if the stock continues to tank. I also own a set of 50 NOK $2.50 puts which have little value right now, but might come in handy for a rainy day if things go wrong for the Finnish phone makers, and a truckload of MSFT $20 puts. If the whole market goes south these cheap plays will quickly pay off under the double boost of getting closer to the strike price, plus benefiting from a higher VIX, or in the case of MSFT provide the basis for $25/$20 bull put spreads. And if the market goes onwards and upwards, that is just fine with me too.
    7 Mar 2012, 07:44 PM Reply Like
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