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Diagonals: Helping me stay Zen while mostly in cash

|Includes: FXE, Range Resources Corporation (RRC)

I'm trying to stay zen-like in cash, but it is extremely hard for me to sit and do nothing-in both life and investing.  I like to be active and feel like I'm making progress, but most days I am glad I don't have much in the market right now.  As Bernanke keeps printing money, Ireland debt problems, currency wars and now the threat of a real war in Korea (maybe Snow can fill us in if he reads this) I'm fine being mostly in cash.  Boring is good sometimes!

 

Instead of trading I'm studying and planning so I'm ready to act when I do feel it is the right time to commit.  Diagonals are one style of trading I plan to do more when I feel like a long-term speculation is in order.  A diagonal is a bit like writing a covered call or covered put on steroids.  Many brokers (I use Interactive Brokers) will allow you to write a call against a long-term option LEAP.   For example, you can buy Jan 2012 in-the money call and sell a Dec 2011 out-of-the money call against it, much like a covered call position on a stock.  What really makes a diagonal fun is that you can also sell puts against a long put as well, so it is like writing covered calls on things you think will go down.  

 

Here is an example from this fall.  I wanted to do a long-term trade on RRC, since it had a good entry point in late September.  RCC was trading at $38.76 and I did not have a lot of capital to commit at that point to buy the stock and write a covered call.  Instead I bought the March $35 call and sold the Nov $40 call against it.  I paid $5.00 for the March call and sold the Nov call for $1.15, making this a $3.85 entry price per contract.  RRC did not follow through and move up right away, so my plan was to keep writing calls each month, possibly getting my cost basis close to zero by March (since I had 4 more opportunities to write calls, I only needed to average $.90 each month.)  

 

In early November, RRC started to move up and went over $40 a share, so I closed the trade on November 8.  The March call had risen in value to $6.70, but the November call was still at $1.15 due to time decay for 5 weeks, so I sold at a net $5.55, making $1.70 per share or about 30% in 5 weeks.  Over that time period, RRC moved up about $2.00 per share, or about 5.15%.  Even with a covered call, I probably would not have made much more than that in the same time period, so I'm sold on this trade that takes a 5% stock move and makes a 30% profit.  What I really like is the risk reward set up.  Buy selling the call against a long-term call I accomplish two things.  I can steadily decrease my cost basis and make this a very low risk trade over time, possibly even risk free if I can sell enough premium.  Second, I am protected against time decay on the call I buy.  

 

My current trading plan is to put 80 to 90 percent of my trading capital into married put type investments and the other 10 to 20 percent into long term diagonals.  I would not want to have too many diagonals, because a big market surge in the wrong direction could hit too much of my portfolio at once.  But I think these trades will be a great profit enhancer used judiciously.

 

You can also trade put diagonals.  Here is a trade I put on yesterday.  I believe that some time between now and January 2012, the Euro will take a dive lower.  With Portugal, Spain and Italy all being shaky and Greece still potentially in the wings with a possibility of default, something major is bound to shake the Euro in the next year.  Here is a very safe trade to do without becoming a currency speculator.  I like to buy in-the-money options because the have more stability than out-of-the money options, so I bought the Jan 2012 $140 put on FXE (trading just over $135 when I bought it) for $11.48.  I sold the Jan 2011 $130 put for $1.05, making for a $10.45 net entry price.  If FXE drops to the $130 strike buy January expiration day, I can make up to $380 on the trade.  So a 30 percent gain is likely if the Euro continues to fall.  If the Euro recovers I will just keep writing out-of-the-money puts and reduce my cost basis as much as possible.  At some point I believe FXE will fall below where it is today and I will make a profit.  If not, I can probably get out of the trade with a small loss or perhaps even eek out a gain with enough premium sales.  

 

I only have $1045 committed to the trade, which is less than 1 percent of my current IRA.  It keeps me feeling like I am doing something when I'm mostly in cash, and I don't have to be tied to my screen like a day trader to make a nice profit.  I think diagonals have the risk/reward setup to be a nice addition for 10 to 20 percent of my portfolio. 

Disclosure: Short FXE