Diagonal spreads are the parsimonious trader's covered call. Rather than buying stock (expensive!) and selling near-month calls against the shares (low percentage return!), the diagonal trader buys call options with expiration a few months out (cheaper!), and sells near-month calls against the contracts (higher percentage return!).
Both covered calls and diagonals have their good points and bad.
With a covered call, I'm never forced to sell my shares and take a loss in the case of a price decline. I can hold on forever, or at least until buy out or Chapter 7 bankruptcy do us part. But shares cost a lot of money compared to options -- shares are unleveraged -- and that reduces the diversification of my holdings, and also lowers my profits as a percentage of investment.
With a diagonal, I'm exposed to the peril of time decay. The long call in my diagonal spread will lose value as it near expiration and will eventually cease to exist. A diagonal forces me to take my losses, even if I think waiting a few months would allow me to recoup. Yet call options are cheaper than shares -- options are leveraged -- and that allows for greater diversification of my holdings and raises my profits as a percentage of investment.
My method of selecting diagonals is as follows:
- For the long option, go at least three months out from the near-month expiration and buy calls with delta as close to 70 as possible. (Delta measures how much an option moves in relation to stock price moves. A 70 delta means that if the stock gains $1, the option gains 70 cents.)
- For the short option, sell near-month calls with a delta between 30 and 40.
- Close the diagonal -- sell the long call -- a month out from expiration, thereby avoiding the greater part of time decay. For example, a diagonal with July expiration will be closed off of my books in mid-June.
That method allows me to sell near-month calls at least three times against the out-month long call, and more if the options inventory requires me to further out than three months for the long calls.
Since diagonal calls depend upon the passage of time for its profits, there is little to be gained from trading in and out as in a directional trade. So I insure my positions by buying protective puts, priced in such a way as to cost about a third of my potential profits. Generally, for insurance, I'm looking at puts having a delta of negative 30, so as to reduce the number of contracts and my transaction costs.
It's not 100% coverage, but it will mitigate potential losses. And since the puts expire the same month as a long call, odds are good that I'll get a portion of the premium back.
In selecting options, I want choose from stocks having high liquidity -- average volume of 5 million shares or more. I want to structure the position so that my risk/reward ratio -- maximum potential loss from the sale of calls divided by max potential profit from their sale -- is 4:1 or less, and within that group, I select for the highest return.
This produces surprisingly few possibilities. For my own account, I also add analyst opinion to the mix. I give priority to stocks ranked top buys by Zacks.
Here are my out-month long-call holdings (with expiration month and strike) against which I'm selling April calls:
- AAPL, July $540
- DFS, July $29
- EFA, June $51
- INTC, July $26
- IWM, June $77
- QCOM, July $60
- QQQ, June $60
- STX, Sept. $24
- WDC, July $35
The three exchange-traded funds -- EFA, IWM and QQQ -- were added to the mix when I was setting up for March expiration, using a different method than I used for the April selection.
Some math tools:
Maximum risk is the cost of the long call minus the price received for selling the short call. It is the net debit paid for the position.
Maximum profit is the strike price of the short call minus the strike of the long call minus the maximum risk (net debit).
Risk/Reward ratio is the maximum risk divided by the maximum profit. I generally round it and display in ratio from as n:1 (4:1 or 2:1).
Bottom line: The diagonal is a complex beast, at the mercy not only of time decay but of implied volatility. Rarely will a position show maximum profit or fall into maximum risk. For my own account, although I like the stability and simplicity of covered calls, the leverage afforded by diagonal spreads is too attractive to pass up.
By the way, why no stock analysis today?
Zacks added only five stocks to its top-buy list, and I hated them all. My daily random selection for analysis from a pool of 675 large-cap stocks turned up little to cheer about.
The shrinking pool of bullish possibilities may suggest a weakening of the markets in advance of a major turn. Or not. I'm still pondering that prospect.
In the meantime, my time-dependent positions -- my diagonals -- are well insured.
I screened the stocks using a tourney bracket with a one-month daily chart and a three-day half-hour chart, and then turned to a five-year weekly chart for the broad context in analyzing the bracket winner. See my essay "10,000 Charts" for a discussion of my screening methods.Disclaimer
Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.