Options Strategy: Diagonal Spreads on High Quality Dividend Payers

Includes: CB, JNJ, MMM, PG, XOM
by: Tom Armistead

Options investors are typically action-oriented, short-term players or speculators, while dividend investors take a longer term view and accept less dramatic returns in favor of stability and predictability.

During the past year, I have upon occasion discussed the use of LEAPs (long term options expiring in January) as a substitute for share ownership on conservative, dividend paying stocks. To me the strategy is contradictory, an intersection of two divergent investment approaches, but potentially profitable.

Case study

In September last year I made a decision to increase my use of this strategy, writing it up here on Seeking Alpha. This was my thinking at the time:

The easy money has been made on small tech and volatility based options strategies. Going forward, with interest rates low and business conditions uncertain, large, well-capitalized and relatively steady performers will command a premium. Reduced volatility makes it attractive to buy options, primarily deep in the money LEAPS expiring in January of 2011. These provide leverage at an affordable premium. Writing short term calls, close to the money over these positions, attractive returns are possible, like covered calls on steroids. If successful in the aggregate they will outperform the 11.5% projected for holding the S&P 500 index.

This article presents a study of my results, focusing on Dividend Aristocrats, using my actual trades. Here is a table, covering Chubb (NYSE:CB), Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG), 3M, (NYSE:MMM), and ExxonMobil (NYSE:XOM).

The positions consisted of LEAPS, long term options expiring in January 2011, deep in the money – typically I selected a strike in the neighborhood of the 52 week low, or at support if it was easily visible on a chart. Over these, I sold shorter term options, out of the money, mostly for periods of 90-180 days. The options sold were intended to offset the time premiums for the long positions, and to provide return if the market did not rise as expected. This approach is generally described as a calender or diagonal spread.

I performed my normal analysis prior to investing and determined that all stocks selected were trading at less than their average multiple on Price/5 Year Average EPS.

Most of the positions are still open . The computations are based on closing values as of 03/08/2010; the bid for long positions, the ask for short positions. In many cases there was some busy work rolling the options or dealing with expirations. The actual commissions are included. XIRR is the spreadsheet function for determining the internal rate of return on an irregular flow of payments. It uses compound interest: the returns shown are annualized accordingly.

For analytical purposes, the options strategy has been compared to simply buying the shares on the same dates, treating 1 contract as being equal to 100 shares. The returns are shown in the shares column. As expected, the options strategy provided a higher rate of return than could have been achieved by buying the shares, in some cases dramatically so. To evaluate how well it worked, I compared the actual dollar amount of profits for the options positions with the profits that would have been made if the trades had been done by means of shares. Hypothetical commissions or dividends were not considered.

Leverage is the actual XIRR for the options transactions, divided by the hypothetical XIRR for the equivalent transaction if done with shares. Efficiency is the actual dollar gains from options divided by the hypothetical gains from shares. In the most successful cases, 5 X leverage was achieved, capturing roughly the same amount of dollars as would have been achieved by use of shares, but deploying far less money.

Where the strategy was less successful, the options did not capture the full dollar amount and effective leverage was reduced. Overall, the strategy provided 2.5 X leverage and captured a little over 50% of the dollar moves. A 33% annualized return is not too shabby, and is meaningfully higher than could have been achieved buying the shares. At the same time, those who bought shares of these stocks during the time frame under consideration are doing well, particularly if you add a few points for the dividends.

Of course I couldn't resist comparing it to the index. Investing proportionately in SPY shares on the sames dates as my trades, an investor would have had an annualized rate of return of 23%.

A successful trade

How it works in practice and the attraction here is best illustrated by the JNJ position (click to enlarge image):

An initial investment of approximately 4,250 yielded profits of 1,275, 30% for 4 months, 107% annualized.

Variable results

The variation is mostly due to the tactics of selling short term, out of the money calls. For PG, as an example, this contributed to missing a large part of a large move. The topside went to the buyer of the out of the money calls. On the CB case, I did not sell calls until about a month ago, because I felt the shares were undervalued and did not want to give away the topside. So, as volatility declined and time passed, the LEAPS lost time value, and did not seriously outperform the shares. Earlier sale of out of the money calls would have improved this situation.

The sale of out of the money calls here is hedging, and there is little reason to indulge in a lot of second guessing. To me, it makes sense to sell at least enough calls over to make theta (time value) neutral for these type positions in the aggregate. All in all, I prefer to have time on my side, so I am willing to accept the diminished returns on the occasional stock that seriously outperforms in return for knowing that every day of range trading puts a few bucks in my pocket.

Selecting the strike of the call sold

Many covered call strategists sell at the money or just out of the money calls monthly. When doing diagonal spreads, my experience as I interpret it suggests additional considerations and a different approach.

If volatility is high when the position is initiated, increasing share prices and/or decreasing volatility can result in the rapid loss of time value on the lower leg. If the upper (short) leg gains a lot of time value or goes deep in the money at the same time, it is possible to wind up with very little profit on a large upward move. The total time value on the calls sold should be equal to or greater than the time value on the long calls when initiating a position under conditions of high volatility.

Another rule of thumb: the combination of the strike price and the premium of the call sold should lie fairly close to the straight line trajectory from the initial share price to the target price and date. It is good to collect premium, but if too much focus is placed on that consideration, the result is that the investor/speculator does a lot of work finding good prospects and then gives the profits to others more opportunistic than himself.

Leveraged investing

Leverage gets a bad name: we have had too much of it from the investment banks and other financial businesses. It's not for everyone. As an individual investor, and not a professional, in discussing leverage I am not giving advice, but only talking shop. That having been said, the use of deep in the money LEAPs as a substitute for share ownership, particularly on low volatility dividend-paying stocks, offers attractively priced leverage with certain built-in advantages compared to alternatives such as using margin.

Risk management

Leverage increases risk. When I am doing it the way I think I should, I hold about 20% cash in my account, and maintain distant expirations on my in-the-money calls. In August or September I will look at the Jan2011 expirations and roll any of them I want to keep out to Jan 2012.

In the event of a sharp drop in the market, the lower leg of a position of this type will gain time value as share prices plunge and volatility increases, giving the investor/speculator a window of opportunity to adjust positions appropriately. If my opinion on the underlying stock has not changed, I deal with these situations by rolling down, typically looking to spend 3 of premium to roll my strike down by 5.

This approach is counterintuitive, accepting further downside risk under adverse market conditions, but it relies on the common sense approach of selling at or near the money options when volatility is extremely high. It is possible to take a nasty round trip and emerge with a decent profit. To execute this defensive maneuver it is necessary to have funds available for the purpose.

Conversely, if the market goes up a lot and volatility declines, it may make sense to roll the lower leg up, particularly if it can be done for a credit in excess of 4 for an interval of 5 or 9 for an interval of 10. While dollar profits are reduced, internal rate of return is increased and the resulting positions are easier to defend in the event the market heads back down. Plus the investor now has cash to respond to opportunities or emergencies.


The strategy selected was suitable for market conditions during the time frame covered by the study. As expected, leverage allowed for out-performance. The call on market direction was correct, the call for out-performance by quality dividend payers was not. The options positions had what I regard as embedded profits in them as of March 8; that is, they will make money as the time value on the options sold decays. A person exiting carefully could have cashed them out at mid bid/ask, adding a few points to the return.

Risk/return is difficult to asses on a small sample and with the combination of leverage and hedging employed. I ran some positions of this type into the March bottom last year and ended the year with excellent returns, albeit at the expense of volatility in excess of that provided by a turbulent market.

As a risk tolerant value investor this strategy makes sense to me at times when I believe that high quality dividend payers are undervalued.

Disclosure: Author holds long positions in MMM, CB, PG and XOM as discussed, no position in JNJ