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McDonald's Modified Diagonal Call Spread

Summary: On 8/13 PT entered into a modified diagonal call spread on Mcdonald's Corp. (NYSE:MCD), which consists of: (i) selling 10 November 57.5 calls (which were at time of sale, slightly "in the money"), (ii) buying 10 March 2010 52.5 calls, and (iii) buying 3 March 60 calls (hence the "modified" in modified diagonal call spread). The cost of the position, including commissions, is a net debit of $5,173.99. The following chart depicts the profit/loss profile (albeit inflated because of a quirk in the OptionsXpress software which assumes a higher than realistic implied volatility (IV) at expiration).

Break-Even Price: Break-even price at expiration, which will depend on implied volatility (IV) of the March calls, is likely around $56.5.

Maximum Profit Price: Because of the 3 March 60s, profit is theoretically unlimited. Profit at $57.5-60$, depending on IV at the expiration date, would likely be around $1200.

Potential Downside: Downside is limited to the net debit, or $5,173.99.

Greeks: At entry, position delta (or sensitivity to a $1.00 change in MCD stock) is 347.77, and gamma (the decrease in delta due to a $1.00 change) is -43.33 (gamma will in turn decrease as the stock rises due to the 3 March 60 calls). Position theta (the increase in the value of the position in a day, assuming a flat stock price and no change in IV) is 9.7 at time of entry, which will increase as we near November expiration and then decrease as the extrinsic value on the November 57.5s evaporates. As position theta approaches negative, I will look to exit the position or roll the November calls to December. Theta will decrease as the stock rises above or dips below the near-month strike price, 57.5. As with any diagonal spread, vega (sensitivity to IV) is substantial - which will be profitable in the event of a sudden increase in general market volatility (but will result in a decrease of the value of the position if volatility continues to decline over the next month).

Rationale: MCD is a terrific diagonal spread candidate because it's a stable, dividend paying, well managed, and recession "resistant" business, with a compelling valuation at around 15x earnings. These factors create a figurative  "floor" on the stock price not too far below current price (52 week low is around $50 per share), and create opportunities for additional trades in the event the shares fall substantially below their current price and valuation becomes even more compelling.

Note that MCD reports earnings on 10/21 which will likely cause a larger than normal increase or decrease in MCD's stock price, and will also result in a decline in extrinsic value of all three options, but disproportionably affect the November 57s. In the event the stock declines drastically following the earnings release, I will look at increasing exposure to the current position, or entering into a similar position at a lower strike price (unless the earnings demonstrate a systemic issue affecting MCD's fundamental valuation).

The ideal outcome here would be for MCD to stay (or finish) relatively flat prior to expiration, allowing me to profit form the decline in the extrinsic value of the November 57.5s, and then roll into the December 57.5s, and so on. A sharp rise in MCD would be profitable but would limit the future potential of this and other positions on MCD given an increased and potentially unsustainable valuation.

On a side note, one way to look at the cost of purchasing an in the money option like the March 52.5s is to compare the extrinsic value to the alternative cost of borrowing funds to purchase the underlying stock. At a value of $6.20 per share, and a MCD stock price of $57.5 on 10/13, the March 52.5s have $1.2 of extrinsic value, and $5 of intrinsic value, which is a 2.2% borrowing cost on the $52 (or about 6-7% annualized once taking into account the effect of the dividend). However, unlike real margin debt, purchasing an option is "non-recourse" - one just pays the extrinsic value (interest), and isn't liable for the entire value of the alternatively borrowed funds. An imperfect analogy to selling short term, at the money, options against long term, in the money, options is borrowing long-term at a low interest rate, and lending short term at a higher interest rate.