Happy new year, folks! Welcome back to the last post in my series on long calendar spreads. We’ve already defined terms, reviewed tips for finding a good underlying, and discussed how to add a little directional spin to your calendar play. In today’s post we’re going to step it up a notch and explore some related territory: diagonal spreads.
A diagonal spread is basically a combination of a vertical spread and a calendar. Let’s start with this example based on the Diamonds (DIA):
DIA at 128.68 on 1/04/08
Buy DIA Mar 137 call at – 1.65
Sell DIA Feb 133 call at + 1.80
Net credit + 0.15
What are we hoping to see happen here? We hope at February expiration the underlying (DIA) will be below the sold option’s strike price (133). The ideal would be if the DIA rose a little bit and settled just below the strike - that is, “ideal” if you handle stress well. If this materializes you’ll have many alternatives for the next trade in the series; we’ll discuss these later in the post.
What’s your max risk then before the February option expires? That boils down to the difference between the strikes, which is 4 points (137 – 133), minus the net credit received, 0.15. For this trade, then, max risk is 3.85 (4 - .15 = 3.85). The max risk scenario would occur when the DIA is above 137 at February expiration. You MUST understand what to do if this turns out to be the case and you were dead wrong on your forecast. Please read my post called “early exercise: part 4”. At the end of the post it talks about “damage control” on calendar spreads. The max risk after the February expiration depends on your next trade.
Decisions, decisions
So, if the stock does stay below 133 on the February expiration, then you have a decision to make. Your first choice would be to sell the 133 call for March; the result would be a straightforward vertical spread (short March 133 and long March 137). This trade implies you think the market will finish below 133 for the month of March – a bearish to neutral outlook once again. The total risk will depend on the amount of credit received for the sale of the second call.
Your second choice might be more attractive if your outlook has changed to more bullish. Playing that outlook is simple: just do nothing. If you do nothing, let the February call option expire worthless and just remain long the March 137 call, you’d be long the call without ultimately paying anything for it, because the credit from the February option contact covered the cost of the March option. Nice, right?
Third choice is to close everything and move on. Obviously with the stock below 133 the February option expired worthless, so we no longer have any short call risk - PLUS we’ll have any value remaining in the long February call. The net result will be a credit for the entire trade of 0.15 (1.80 – 1.65); and you can then sell the March option and capture the remaining premium in the contract. This should help your bottom line.
Summary
In the big scheme of things, what’s your market outlook if you’re putting on diagonals? It’s a little convoluted. To start for the month of February, you’re neutral to bearish. I mentioned “neutral” first because the better scenario is if DIA does not go down. In that case, the March contact strike will be closer to the stock price and hence have more value, which is good because you own the contract.
After the February expiration you have to re-evaluate your outlook with three choices on the table: 1) sell a new March call, if you’re bearish or 2) do nothing and remain long the March call if you’re bullish. 3) close the entire position (for either a profit or loss) and move on to the next trade.
That’s all I’ve got for today, folks. Shoot me your questions or comments – let’s see where the discussion leads us next.
Regards,
Brian (OG)
[image: tic tac toe by bravo_echo_november on flickr]
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.
