Options Strategy And Tactics: Diagonal Spreads

by: Tom Armistead

Summary

The math behind options pricing and the multiplicity of possible strategies create a daunting amount of complexity.

Simple options strategies, when used by investors who have a well-researched directional opinion on the stocks involved, can improve returns and reduce risk.

Wall Street doesn't always provide a level playing field: however, investors who use options can select areas where they are not at a disadvantage.

This article discusses LEAPS covered calls, a type of diagonal call spread.

Rob Marstrand drew considerable comments with his recent article discouraging the use of options. I've used them for many years now with satisfactory results. As a response to Marstrand's negativity, this article discusses a simple strategy that has worked for me.

Deep in the Money, Distant Expiration Calls

LEAPS (Long-Term Equity Appreciation Securities) can be used as a substitute for owning stock. These calls expire as much as three years in the future, providing an opportunity to participate in share price appreciation with less capital than would be required to own the shares outright.

I generally buy them with a strike that is 80% of the share price, to expire a year or more in the future. For example, with IBM trading in the $180 area, I would buy Jan 19 145 calls, paying approximately $38.50, of which $3.50 is time value. I think of the time value as interest on $145, since that is the additional money required if I were to buy the shares. Doing the math, it works out to 1.3% per year. As a practical matter, I'm happy with 2% on low volatility stocks.

The price of these calls will track the shares very closely. As such, the nominal leverage here is 5:1. Leverage works both ways, as is well-known. However, the downside is clearly defined and limited by the 145 strike: my exposure to loss is limited to the $38.50 premium paid.

Suppose 6 months go by, and IBM plunges to the $145 level. Using an options calculator and leaving volatility unchanged, I estimate my calls will be worth $14.64, all time value. So my loss will be cushioned by the increase in time value from $3.50 to $14.64, $11.14 in this case. Rather than losing $35, I will have lost $27.36.

If instead IBM goes to $215, my calls will be worth $71, of which $1 is time value, for a gain of $32.50. So the leverage is not completely symmetrical: if the share price increases by $35, the gain is more than the loss would be if the price goes down by the same amount. I think of this as a volatility hedge.

Rolling Up and Down

Continuing with the downward scenario, six months in the future, if IBM goes down to $145, I can cash in the increased time value by either selling (if I have lost confidence in the company) or rolling down.

Again using an online options calculator, to roll down from 145 to 140 would cost $2.25; from 145 to 135 would be $5.87. Buying a $5 tranche for $2.25 makes sense to me. As a practical matter, I'm happy if I can do it for $3.50 or less. Or for a $10 slice, $7.00 or less.

If IBM now goes back up to the original starting point, $180, I can roll back up. The options calculator tells me I'll receive $3.90 to roll up 5, or $8.83 to roll up 10. In practice, I've been able to get better than $4.50 for 5 or $9.00 for 10.

This works in practice the same as it does in theory. Investing in IBM over the past few years, it tanked to as low as $118 last year, before recovering to as high as $182 recently. I rolled down, spending 67.4 cents on the dollar, and then back up, receiving 90.3 cents per dollar. These small amounts add up over time.

Rolling Out

I roll out on a regular basis. By keeping expirations well into the future, the volatility hedge is maximized and the investor avoids pressure around expirations. Rolling out one year and thinking of the cost as interest on the amount of the strike, I try to pay about 2%. It will be more expensive for volatile situations.

Selling Covered Calls - Creating a Diagonal Spread

I frequently sell covered calls against my LEAPS. I prefer out of the money, with a duration of 3 to 5 months. The strategy may be described as a LEAPS covered call, or a diagonal spread, since the expiration dates are not uniform. As a rule of thumb, I sell at 8% above the share price, or at a price where the time value received for selling the call is equal to the time value of the underlying LEAPS.

Across the portfolio, time value received is greater than time value paid. As such, time is on my side; I will make money if the stock goes nowhere.

The standard recommendation for selling covered calls is to stay very close to the money and short duration, to maximize decay in your favor. In the interest of controlling trading costs, and not being busy all the time, I prefer the 3 to 5 months and about 8% out of the money.

I don't take evasive action to avoid being called away. I try to stay with quarterly options, and will roll them forward if the return is attractive. For me, what works is thinking of it as providing a service. For the premium received, I stand ready to deliver the stock at the agreed price at any time up to and including expiration.

I always earn my premium. In most cases, I have a profit from appreciation of the underlying LEAPS call, so I'm happy the short call went into the money. I will sell covered calls that lock in a loss, if my opinion of the underlying has changed. If a stock goes down and I still believe in the company, I avoid selling covered calls until it appreciates to something I think is realistic.

Results over Time

From 2009 to 2016, tracking cash flows into and out of my discretionary account and applying the spreadsheet XIRR function, the IRR has been 25.9%. Most positions have been held by means of the options strategy described here.

The S&P 500 (NYSEARCA:SPY) would have returned 14.5% over the same period, including dividends.

Four years (out of eight) featured returns of 50% or more. The others averaged -2.6%. I have a tendency to concentrate positions and stick to my guns. The LEAPS covered call or diagonal spread strategy has done well when applied to stable quality companies, DGI or CCC types.

Caveats and Reservations

Options provide leverage, which cuts both ways. While students of the Greeks will monitor position size using delta, I have found that it's much safer to calculate it by multiplying the number of shares controlled by the share price. Treat 1 option as 100 shares, even if you have sold covered calls against the position.

The strategy described here relies on rolling positions down when they move against you. To do so, it is necessary to have funds available at times when the market is declining. I average about 30% cash, more like 50% when the market is rallying strongly. These cash funds are at risk, since they will be shoved across the line in due course, and returns need to be computed accordingly.

With required cash support in mind, the apparent 5:1 leverage discussed earlier in the article works out closer to 2.5:1 in practice.

Selling covered calls gives away the upside, while rolling down adds to the downside. Rolling down is counterintuitive and requires a strong stomach to keep pushing money across the line. If you're wrong and the stock doesn't go back up, it's painful.

Returns are very lumpy. I've been withdrawing funds on a regular basis, to supplement social security. Withdrawing large sums during a losing year makes it hard to recover, since the good year occurs from a lower base.

Taxes are an issue. Much of the profit is short-term capital gains. Wash sale rules can defer the deduction of losses. Preparing Schedule D is an issue, and requires the use of specialized software, or the expenditure of substantial time working with details. Some investors are comfortable trading options in a retirement account. I haven't done it, under the belief that retirement funds should be invested in something that's more predictable, like index funds on the S&P 500, or diversified holdings of DGI type stocks.

It should be noted that long and leveraged was basically a sound posture for the eight years discussed here. Applying leverage to a situation that is likely to go up 15% a year makes sense, as I opined back in 2010. The current market does not offer these fine possibilities: I don't think it's realistic to look for more than 7% annualized from where we are. As a cautionary observation, attempts to juice low expected returns by the application of leverage tend to backfire.

Other Strategies

Going over the comments on Marstrand's article, many investors who use options have found a niche where they're comfortable and satisfied with their results. Here are a few strategies I've used:

  • Risk reversals and variants thereof
  • Vertical call spreads
  • Cash secured puts
  • Covered Strangles
  • Long deep in the money puts

Over the years I've grown accustomed to the diagonal spread or LEAPS covered call strategy described here. It's my niche and comfort zone, and at this point I seldom use anything else.

I don't buy out of the money calls. It's just too discouraging to watch time value bleed away while the stock goes nowhere. I resist the temptation to sell naked puts or calls. Selling puts has been described as picking up nickels in front of a bulldozer: here's a link to an article discussing the risks involved.

As a retail investor, I have no interest in butterflies, condors or other more complex, volatility based strategies. I prefer to develop directional opinions on stocks and express them with options. While I have used strategies that involve the sale of puts in the past, I've avoided it in recent years, for safety and simplicity.

General Philosophy

I strive at all times to sell more time premium than I buy. The thinking is to have time on my side and to be paid for leaving my money on the table. I take about 95% bullish positions, on the grounds that the market goes up more than it goes down.

When buying options, I prefer in the money and long duration. When selling, I prefer out of the money and shorter durations.

Disclosure: I am/we are long IBM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I'm an active options trader and maintain a portfolio using the strategy described here.

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