Understanding Diagonal Spreads

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Understanding Diagonal Spreads

  1. 1. Smart Options Diagonal SpreadsIntroductionMany long-time BigTrends customers have asked us why we recently decided to change ourSmart Options service from a simple, single-leg option buying service into our new strategy oftrading Diagonal Spreads.Frankly, many of you were quite worried, and said you didn’t understand the strategy and thatgave you concerns about the risks you might be taking. Perhaps your brokerage firm cautionedyou against them also -- if it’s not an options-centered firm, many brokers don’t understand thestrategy and therefore declare it “risky”.My goal in this whitepaper is to explain what makes up a diagonal spread; show you the risks(and potential rewards) of the strategy; and help you get your broker ready to execute yourtrades instead of scaring you -- or help you find a new broker if they won’t.Here’s what we’ll be covering: 1. The Concept of “Income Trading” 2. Covered Call Example 3. What Makes A Diagonal Strategy Different? 4. Comparing stock vs. in-the-money call option 5. Constructing the Diagonal 6. Exiting the Trade 7. Typical Brokerage RequirementsSo let’s get started with Understanding Diagonal SpreadsThe Concept of “Income Trading”Many new options traders are seriously intimidated by the idea of owning two options on thesame underlying stock at the same time, and miss out on all the possible rewards that can comefrom utilizing options in all of the ways that they can be used.The idea of income trading is not new -- people do it every day. The concept is that you hold anasset of some sort -- think of it as a longer-term asset like a house. But you aren’t fully utilizingit, you aren’t living in the house, and you want to lower your cost of continuing to own the asset.Understanding Diagonal Spreads © 2010, BigTrends
  2. 2. What can you do?I’m sure you rapidly came to the idea that you could rent the house to someone else and bringin some cashflow to offset your mortgage payments. This is exactly what income trading isall about. Let’s look at the single most common options strategy on Earth for a betterunderstanding -- the Covered Call.Covered Call ExampleLet’s say that Mary has 1,000 shares of a stock that she bought a while ago for $50, and thatthe stock hasn’t moved at all and is recently trading for $50.00 per share. Mary’s consideringher alternatives: Value $ Gain % Change Skyrocket to $100! $100,000 $50,000 100% Stock rallies to $54 $54,000 $4,000 8% 1000 Shares @$50 $50,000 break even 0% Stock drops to $46 $46,000 ($4,000) 8% Stock imitates a lawn dart and goes to zero $0 ($50,000) (100%)I know which outcome I’m rooting for!Now, obviously the chance of the stock going to zero is remote -- but as we saw in 2008 andagain in the “Flash Crash” in 2010, a remote chance is NOT no chance.The covered call is, as we pointed out in our example above, simliar to “taking in a renter” onyour asset -- this time, it’s your stock holding instead of your house. The way this works is: ● You sell a call option on the same underlying symbol as your desired stock ● The income you bring in by selling the call option lowers your cost basis on the stock. This also has the effect of lowering your break-even point if the stock should subsequently sell off. ● You already own the stock, so you don’t need to do anything with itNote that if you don’t currently own the stock, you can buy it at the same time, in the sametransaction. It results in the same position. Some brokers call this a “buy-write” instead of acovered call because you’re doing both transactions simultaneously.Let’s look at it like we did the stock trade, but this time, we’re going to sell a call option with 40Understanding Diagonal Spreads © 2010, BigTrends
  3. 3. days until expiration at the $55 strike price, bringing in $1.50 per option.When we say that we bring in $1.50 per option, remember that there is an options multiplier(typically 100, as in 100 shares of stock) that we have to multiply the option value by. So if wesell the option for $1.50, we bring in $150.00 per option.Understanding Diagonal Spreads © 2010, BigTrends
  4. 4. Since we own 1,000 shares of the stock in this example, we can sell 10 contracts in this“covered” example -- the stock “covers” the short call’s potential risk to your brokerage firm. Stock Price Stock P/L Short Call Combined P/L Net P/L (@expiration) $60 $10,000 ($3,500) $6,500 $55 $5,000 $1,500 $6,500 $50 breakeven $1,500 $1,500 $48.50 ($1,500) $1,500 $0 $45 ($5,000) $1,500 ($3,500) $40 ($10,000) $1,500 ($8,500) $0 ($50,000) $1,500 ($48,500)As you can see here, that income that you bring in from selling the short call caps yourmaximum possible gain, but provides some downside protection as the stock drops. Howmuch downside protection? The amount that the call is sold for -- $1.50 per option. So with thestock at $50 per share, minus the $1.50 we sold the call for, our new, lower breakeven price is$48.50 per share!Understanding Diagonal Spreads © 2010, BigTrends
  5. 5. Risk Diagram Image courtesy of trademonsterThis image above shows the risk and reward graph of the covered call, with the stock price onthe horizontal axis and the profit/loss in dollars on the vertical axis.RisksIn either of these cases, as you can see from the tables above, you have to be at leastmoderately bullish on the prospects of the stock. If not, the best trade is to exit the positionentirely. The income you bring in provides a small amount of downside protection, but does notinsulate you from a big downside move.RewardsCovered Call trades can bring in additional income if a stock stays in the same place or rallies.But those gains are capped once the stock starts trading above the strike price you’ve sold.In our example above, if the stock goes nowhere -- just stays at $50 a share -- you keep the$1,500 for the sold call. Divide that $1,500 into the $50,000 that the stock holding is worth, andyou can see that for about a month and a half (40 days), you have a 3% return. Huge winner?Nope. But a consistent trade that works well in slowly upward grinding markets (or stocks), andyou can do it month in, month out.Understanding Diagonal Spreads © 2010, BigTrends
  6. 6. Special NotePAY ATTENTION -- this is the most common mistake new options traders have!You want the stock to trade up to the strike price. You don’t want it to drop. It’s OK if it stays inthe same place, but you’re still in a bullish position.And if it shoots way up and through your strike price, you’ll have to console yourself about thegains that might have been with the gains you actually have in your pocket. (I’ll try not tocry you a river.)Around this point, you’re probably muttering to yourself, “so when is this guy going to talk aboutDiagonal Spreads, exactly?” Right now! Turn the page...Understanding Diagonal Spreads © 2010, BigTrends
  7. 7. What Makes a Diagonal Spread Different?I’m sure that all the explanation of the covered call was review for many of you. What does thishave to do with diagonal spreads, you ask? It’s simple: a diagonal spread is simply a coveredcall -- but you exchange the stock holding for a longer-term option.In the case of the Smart Options newsletter service, BigTrends uses a deep in-the-money (ITM)in place of the stock. We choose these options because they move more like the stock will thanan at-the-money (ATM) call option would. In options parlance, ITM options have a higher deltathan ATM options. This simply means that when the stock moves up or down by $1.00, theseITM options will move more than the ATM options will.If we look at a simple exchange of the stock for an option expiring roughly 6 months from thetime of this writing, and find a delta higher than 70%, it leads us to the $42 strike price, expiringin March ‘11. This option is quoted at about $6.50 per option.Comparing Long Stock with a Deep-In-The-Money Call OptionLet’s just compare the stock against the new long option: Cost Max Gain Max LossLong 1000 shares at $50 $50,000 infinite $50,000Long 10 contracts at $6.50 per option $6,500 infinite $6,500Understanding Diagonal Spreads © 2010, BigTrends
  8. 8. Here’s how the long option looks on a risk graph: Image courtesy of trademonster...and since the options will gain 70¢ of the next $1.00 gain in the stock (and each $1 thereafter,a little more than 70¢), this seems to be substantially better utilization of your trading capital,with one exception: If this is a stock you intend (or are required) to hold for a very long time,then owning the stock is a better alternative.Speaking Diagonally...Let’s recap what we’ve covered to this point, and then we’ll tie it all together. 1. Covered Calls give an equity investor the ability to bring in immediate income on their stock or ETF holdings. In our example above, roughly a 3% yield was demonstrated. 2. A deep in the money call behaves very similarly to (but not exactly like) a stock position. 3. A Diagonal Spread uses a deep-in-the-money call option as a substitute for a stock (or ETF)Understanding Diagonal Spreads © 2010, BigTrends
  9. 9. So what does this thing look like when we pull it all together? ● We’re still going to sell the Dec 50 call option for $1.00 ● Instead of buying the stock for $50 per share, we’re buying the Mar 42 call for $6.50 Buy Mar 42 call $6.50 Sell Dec 50 call ($1.00) Net debit for diagonal spread $5.50 Options Multiplier (100 shares per contract) $550 per spread [times] 10 contracts (ea.) to equal 1,000 shares $5,500 total riskThe same information, shown another way in the snapshot analysis: Image courtesy of trademonsterFrom the snapshot overview of the position, you can see here that the highest potential profitfor this trade happens at December expiration, and if the stock happens to be trading right atthe strike price of the short option ($50). If we were to hold it that long, there is a theoreticallypossible 62% return on this trade instead of the 3% that we had with the covered call.Understanding Diagonal Spreads © 2010, BigTrends
  10. 10. So...62% vs. 3%. Why no exclamation points? Why no huge bold text saying “WOW!”?Because this is extremely unlikely to happen. The way that BigTrends views these trades isthat if we can get a 20-30% return, we’re going to take the profits, exit the trade, and look foranother opportunity. When might that be possible?Let’s take a look at the very cool Spectral Analysis tool that online broker tradeMONSTER haswith this trade and see what it can show us. Image courtesy of trademonsterUnderstanding Diagonal Spreads © 2010, BigTrends
  11. 11. In this example, instead of the simple analysis we have been looking at throughout the paper,we can “what-if” every combination of stock price, volatility assumption, and date between todayand the expiration of the short call. The top image actually plots nearly 30,000 data points andshows them all in a nice red to green image showing us where our potential profit and loss is.We can see that if this stock retests its mid-October highs by mid-November and returns to$48.24 per share (from the $45.74 you can see it is currently trading at in the top right corner),we would be looking at roughly a $1,400 profit, or 25% gain compared to the $5,500 invested.Also, note in the bottom left of the image, our breakeven point on this trade is approximately$44.50, so we have some downside protection on this trade as well. [Ed. Note: What’s not shown in the screenshot is that this tool also will let you change the volatility assumption and see what happens to the trade when volatility goes up or down -- a great educational tool. If you’d like to check it out, visit tradeMONSTER’s website. They let you open an account without funding it, and have a $50,000 paper trading platform to let you practice and see how you like it.]Exiting the TradeOne important note is that you should put the diagonal on and take it off as a package, on oneorder ticket. If you enter the trade with 10 contracts, you might take a few of them off and leavethe rest a little longer.But don’t buy back the short calls and leave the long call on unless you’re rolling that short callto the next month. And you should only do this because the chart is telling you it still makessense -- not just because the trade worked out the last time you tried it!Typical Online Brokerage RequirementsSo what do you need to be able to trade these strategies in your typical online brokerageaccount? The unfortunate truth is that it varies from broker to broker.I spent many years in the brokerage business, and I can attest that in spite of what people think,the vast majority of people working in the brokerage business do not understand anything aboutoptions and how they work -- unless they have specialized in them.But there are options-intelligent brokers out there who understand these instruments andunderstand that limited risk trades are just that -- limited risk. Often, they’re lower risk thanowning the stock.The risk of the trade we’ve examined in this paper is absolutely limited to the $5,500 you investin it. There is no way for you to ever lose more than that. Even if you woke up tomorrowmorning and the stock has “pulled an Enron” and opened at zero.Given that, trading these strategies isn’t solely appropriate for speculators -- you can do theseUnderstanding Diagonal Spreads © 2010, BigTrends
  12. 12. trades in your retirement accounts -- IRA’s, Keogh’s, PSP’s, whatever. The trick is finding abroker that will let you.As of the time of this writing, we believe that this strategy is permitted in both brokerage andretirement accounts by: ● tradeMONSTER ● ThinkOrSwim ● optionsXpress ● Trade KingYours may also allow you to trade diagonals, although you may have to fill out an optionsauthorization form to do so. If your broker tells you that you have to trade a certain number of any other strategy (covered calls, buying single options, etc.) before you can trade these lower risk strategies, IT’S TIME TO FIND ANOTHER BROKER, one that treats you like an adult. Any of the firms above are fine places to start your search.Wrap UpBetter utilization of your trading capital, higher probability of winners, and superior returnscompared to covered calls. Diagonal spreads have many situations where they can succeedand BigTrends’ Smart Options allows you to pair this options strategy with the solid technicalanalysis and stock picking skills that the BigTrends Research team uses every day on behalf ofour subscribers.Understanding Diagonal Spreads © 2010, BigTrends

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