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Diagonal Call

Description

Description

DiagonalCall

Steps to trading a Diagonal Call Spread

  1. Buy lower strike longer term expiration calls
  2. Sell the same number of higher strike calls with a shorter expiration date.

Steps In

  • Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily Volume (ADV)
  • Try to ensure that the trend is upward or rangebound and identify a clear area of support

Steps Out

  • Manage your position according to the rules defined in your Trading Plan
  • If the stock closes above the higher strike at expiration, you will be exercised. You will sell your long call, buy the stock at the market price, deliver it at the higher strike price, whilst having profited from both the option premium you received and the uplift in the long option premium. Exercise of the short option is automatic. Do not exercise the long option or you will forfeit its time value.
  • If the stock remains below the higher strike but above your stop loss, let the short call expire worthless and keep the entire premium. If you like you can then write another call for the following month.
  • If the stock falls below your stop loss, then either sell the long option (if you're approved for naked call writing), or reverse the entire position.

Context

Your Outlook

  • With Diagonal Call spreads, your outlook is bullish.

Rationale

  • To generate income against your longer term long position by selling calls and receiving the premium.

Net Position

  • This is a net debit trade because your bought calls will be more expensive than your sold calls which are OTM and also have less time value.
  • Your maximum risk on the trade itself is limited to the net debit of the bought calls less the sold calls. Your maximum reward on the trade occurs when the stock price is at the sold call strike price at the expiration of the sold call.

Effect of Time Decay

  • Time decay affects your Diagonal Call trade in a mixed fashion. It erodes the value of the long call but helps you with your income strategy by eroding the value faster on the short call.

Appropriate Time Period to Trade

  • You will be safer to choose a long time to expiration with the long call and a short time (1 month) for the short call.

Risk Profile

  • Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily Volume (ADV)
  • Try to ensure that the trend is upward or rangebound and identify a clear area of support

Selecting the Option

  • Choose options with adequate liquidity, open interest should be at least 100, preferably 500
  • Lower strike: look for either the ATM or ITM (ideally about 10-20% ITM preferred) strike below the current stock price. If you're bullish, then choose a lower strike, if neutral choose the ATM strike in anticipation of writing more calls in the future.
  • Higher strike: look for OTM by more than 1 strike to enable the long call to rise in value if you get exercised on the short call.
  • Look for over 6 months for the long option.

Maximum Risk
  • Limited to the net debit paid
Maximum Reward
  • [long call value at the time of the short call expiration, when the stock price is at the higher strike price] less [net debit]
Breakeven to the Downside
  • Depends on the value of the long call option at the time of the short call expiration.
Breakeven to the Upside
  • Depends on the value of the long call option at the time of the short call expiration.

The Greeks

The Greeks

Expiration
Today - 1 month
Time(t) - 5 days

Theta

Time Decay is at its most helpful around the higher strike price.

Delta

Delta (speed) is at its fastest either side of the higher strike price. The blue line represents the position today (approx 1 month away from the short call's expiration) and the magenta line represents the position where the short option has only 5 days to expiration.
CallDiagonal

Vega

Volatility is generally helpful.

Gamma

Gamma (acceleration) peaks inversely around the higher strike price.

Rho

Higher interest rates become more helpful to the position as the underlying asset price rises.

Exiting the Position

Exiting the Position

  • With this strategy you can simply unravel the spread by buying back the calls you sold and selling the calls you bought in the first place.
  • Advanced traders may leg up and down as the underlying asset fluctuates up and down. In this way the trader will be taking smaller incremental profits before the expiration of the trade.

Mitigating a loss

  • Unravel the trade as above.
  • Advanced traders may choose to only partially unravel the spread leg by leg. In this way they will leave one leg of the spread exposed in order to attempt to profit from it.

Pros and Cons

Advantages

  • Generate [monthly] income
  • Can profit from rangebound stocks and make a higher yield than a Covered Call

Disadvantages

  • Capped upside if the stock rises
  • Can lose on the upside if the stock rises significantly
  • High yield does not necessarily mean a profitable or high probability profitable trade

Articles

Scenario

Real Example 19 March 2003: MSFT @ $26.00 (Historical Volatility @ 40%)

Buy Jan 2005 $25.00 strike calls @ $6.60
Sell April 2003 $27.50 strike calls @ $0.55

At April expiration:

  1. Scenario: stock falls to $23.00

    Long calls worth approximately $4.28; loss so far = $2.32
    Short calls expire worthless; profit $0.55

    No exercise

    Total position = $6.60 + $0.55 - $2.32 = $4.83 = loss of $1.77

  2. Scenario: stock falls to $25.00

    Long calls worth approximately $5.46; loss so far = $1.16
    Short calls expire worthless; profit $0.55

    No exercise

    Total position = $6.60 + $0.55 - $1.16 = $5.99 = loss of $0.61

  3. Scenario: stock stays at $26.00

    Long calls worth approximately $6.09; loss so far = $0.51
    Short calls expire worthless; profit $0.55

    No exercise

    Total position = $6.60 + $0.55 - $0.51 = $6.64 = profit of $0.04

  4. Scenario: stock rises to $27.50

    Long calls worth approximately $7.09; profit so far = $0.49
    Short calls expire worthless; profit $0.55

    No exercise

    Total position = $6.60 + $0.55 + $0.49 = $7.64 = profit of $1.04

  5. Scenario: stock rises to $30.00

    Long calls worth approximately $8.82; profit so far = $2.22
    Short calls expire $2.50 ITM

    Procedure: sell bought calls; buy stock at current price and sell at strike price

    Exercised at $27.50

    Buy stock @ $30.00
    Sell stock @ $27.50
    Loss = $2.50

    Sell long call for a profit = $2.22
    Keep short call premium = $0.55
    Loss on Exercise = $2.50

    Total position = $0.27 profit

    If you tried to exercise the bought call:

    Procedure: exercise bought calls @ $25.00; deliver stock @ $27.50 for exercised sold call

    Buy call @ $6.60
    Sell call @ $0.55
    Net cost = $6.05

    Buy stock @ $25.00
    Sell stock @ $27.50
    Net profit @ $2.50

    Total = $2.50 - $6.05 = loss of $3.55

    Lesson: Never exercise a long term option because you'll miss out on Time Value!