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Trade of the Week - Call Diagonal Spread (3/2/2010)

It's been a while since I've done a diagonal spread trade tutorial so I thought I'd throw one out. As I mentioned in my newsletter, I'm shifting my bias to a more bullish stance.

Diagonal spread trade setup

Buy IWM May/March Quarterly 59/66  diagonal spread
Target ROI
At least 21%
1. Roll the short strike if I can do so for $.50-.60
2. Roll the short strike if within 4-5 days
3. Exit the trade if the value drops to $2.88
4. Exit the trade completely if within 4-5 days of expiration
Debit $5.76

This is a 1 1/2 month $7 wide diagonal spread. That means I'll get approximately two rolls in plus perhaps a final close as well. That's plenty of opportunity to make money on this trade if it goes as planned.

Why this strategy

Since I've recently become a little more bullish, I have decided to put on a longer term bullish position. I will probably be balancing out my portfolio longer term but I do want to take advantage of the recent move.

The nice thing about the diagonal spread is that it gives the trade an opportunity to develop in this turbulent market. This trade is a combination of a calendar spread and a vertical spread so I really get the best of both worlds. With the calendar spread component, I have the ability to roll the short $66 two times, picking up additional credit each time. That will help reduce the net debit on the trade.

I chose do this trade on the IWM because it (and the RUT index) has been showing a little more strength than the other indices. Therefore, I think it has a better chance of success.

Choosing the right strike prices

My diagonal spread trading plan suggests buying a call several months out having a delta of around .7 - .8 and selling a call in the near month having a delta around .25 - .30. That's the ideal. Of course it's often difficult to get an exact fit. I was able to find long strike out in May and had a delta right at .8, which is the $59. Unfortunately, it was a little harder to find a short strike that fit my parameters. Looking at the March expiration, there really isn't much time left so I went to the March quarterlies. Next, I wasn't able to find a strike that fell within my ideal range. I chose to go with the $66, which had a delta of .32.

Diagonal spread strike selection

The thing that I wanted to point out in the above picture is the extrinsic value (the time premium portion of the option) of the long strike versus the price I receive for the short strike almost cancel each other out. What that means is that I essentially got the long option for pure intrinsic value.

Risk/Reward analysis

Like calendar spreads, it's a little harder to calculate the potential return on a diagonal spread. However I can make a quick initial evaluation.

This diagonal spread costs $5.76 and is a $7 wide spread. That means that if the IWM moves up strongly and through the $66 strike, I could make $1.24, which is a 21% ROI. That in itself is enough to make me want to take the trade.

Now... let's take a look at the potential up side taking into account the rolls.

In the above picture, I've switched the view to a one month calendar spread with theoretical price displayed. I've moved time forward to three days before expiration and the price up $1, which would project the future price of IWM to be about $.50 short of the strike on that date. With those two parameters set, the value of the roll could be around $.69. Since I get two rolls, I could pick up another $1.38, which would increase my potential profit to $2.62 or 45% ROI.

In terms of risk, I can start with the basic debit of $5.76 since I could lose that entire amount if the trade isn't managed. I don't intend to allow the trade to go that far wrong. In fact, my exit plan is to close the trade if it loses 1/2 the value of my initial investment. That means my risk is now reduced to $2.88.

Position sizing

Now that I have all those pieces together, I can determine my position size. I know I will only be risking 2% of my portfolio ($19,077) or  $381. Since I will be risking $288, I will only be buying one contract.

Exit plan

With the diagonal spread, my exit plan is a little different. I have already stated my plan to close the trade if it loses 1/2 the initial debit. I will also be rolling the short strike under the following conditions.

  1. I will roll the short strike if I'm within 4-5 days of expiration
  2. I will roll the short strike if I can do so for at least $.50.
  3. If the trade goes all the way to May, I will close the trade when within 4-5 days of expiration.

Portfolio Impact

This diagonal spread is a bullish position that will offset some of the bearish bias that existed in the portfolio. As we can see below, the portfolio now has a positive bias and more theta.

If the trend continues, I will be adding more bullish trades to the portfolio. Look for maybe another vertical spread perhaps an iron condor.

Update 3/9/2010

A week after putting this diagonal spread on, IWM has moved up quite a ways. In fact, IWM is currently above my short strike by $.50 or so. That makes the value of the spread currently worth $6.52.

If the IWM is already through my short strike then why isn't the diagonal spread worth $7? Because there is still too much time value left in my short strike. In fact the time value portion of the short March quarterly $66 is just over $1. Until that part melts off, the spread will not achieve its full value.

What I'd like to see happen is that in a week or two, have the IWM pull back to the $66 area where I can then roll the March to April. I will be looking to do that when I can get $.50 - $.60. The current roll value is only $.40.

Update 3/22/2010

Wow! The IWM has moved up quite a lot, although it has pulled back Friday and initially this morning.

My diagonal spread is completely ITM on both sides and is almost worth the $7 spread if I were to close the trade right now. Friday I actually attempted to roll the March quarterly 66 short call to April for $.50 but had no luck getting filled.

Monday morning with the initial sell-off, I was able to get the roll in from the March quarterly to the April cycle for $.51. That isn't the $.60 I was hoping for but not too bad regardless. That makes my cost basis $5.25 while my spread is still completely ITM. That makes my potential profit $1.75 on a $5.25 basis or 33% ROI.

I'll be continuing to monitor this position but for now, there won't be a whole lot to do until we get closer to the April expiration date, which is about 3 weeks away. However, if I can pick up another $.50-.60 on another roll, I'll be balancing that out with my other rules to look for the optimum time to do so.

Update 4/5/2010

The IWM is pretty much where it was at the last update at right around $68. That means I'm currently sitting about $2 above my short strike, which really means both strikes of this diagonal spread are in the money by a ways. That's both good and bad.

I say it's good because that's somewhat the goal of this trade is to be fully ITM. Since my cost basis is only $5.26 but the spread is worth $7, I'd make $1.74. I say it's bad because I still have one roll left in the trade, which could be used to lower my cost basis even more. The ideal point to do a roll is when the price is closer to the short strike.

We're getting close to about 10 days until expiration, which I am starting to consider rolling. I see two possibilities at this point. I can roll the short April $66 to May for about $.80 and lower my basis to about $4.46. That would yield a profit of about $2.54 and an ROI of 44% (on my original $5.75 investment).

On the other hand, I could currently roll from April $66 to a May $67 for about $.10 credit. That lowers my cost basis to $5.16 BUT I now have an $8 spread so my profit would be $2.84 and my ROI is 49%. It appears then that a roll up as well as out may be a good idea as it gives me a better overall ROI.

I went ahead and executed the roll from April $66 to May $67 and received $.10 credit. That leaves me with a $8 wide long vertical spread. It's a good thing I did because just a few minutes after executing this order, the market took off and never looked back.

All that remains is to wait 30 days or so and look for an opportunity to close the trade.

Update 4/21/2010

Not much has happened as several weeks have gone by since the roll. The IWM recently experienced a slight pullback but it hasn't really changed the position at all. There's still just over 3 weeks until expiration so we'll have to wait a little longer to take any action.

I wanted to use this space to talk about managing the trade as it nears expiration. Obviously I could simply look for an opportunity to sell this spread back for as close to $8 as possible. Alternatively, I could simply let the trade go to expiration and allow both sides to be exercised. Sometimes though assignment fees can be more than the simple commission plus the net difference between the full $8 I'd get on assignment and what I could sell the spread back for.

There is another alternative to consider. I could roll the entire trade out in time and up in strike prices. If I thought that IWM would continue to be bullish for the next few months, this might be an attractive option (no pun intended). Let's look at this a little closer.

When I first entered this trade, the delta on my long strike was about .80 and for the short strike, it was .32. Looking at the August expiration cycle for a new long position, I can find a long strike at $66 with a delta of .77. I can also find a June short strike at $75 with a delta of .31. If I was to execute a roll of my existing position to the new position for a credit of about $.98, that would result in a $9 wide diagonal spread for a net debit of $4.17.

That's a great position to be holding if I continue to be bullish on IWM. I'm going to be waiting a little longer before I make a decision on how to handle this trade. We have probably about 2 weeks left before any action needs to be taken. One thing to keep in mind is that I could simply close this trade and enter another similar to the one I just outlined - treating it as a separate trade.

Update 5/4/2010

With another week or more passing, this trade has continued to build in value. Today, I could sell the spread back for $7.68. That means there is still $.32 left in time premium since this is an $8 wide spread.

The market is starting to show some fluctuation in it's momentum. Even with the recent selling, this trade has remained in good shape, largely due to the early strong movement. With the short $67 call, there's still $6 for the IWM to fall before the position would be at risk. However, if the fall of 2008 taught us anything, it's that this kind of move definitely possible in certain climates.

We're now in a time window where the trade can be closed at any time. It's just a matter of how important that last $.38 is. At this point, I'm not so much holding out for the last $.32 as I am waiting to see if I'll just close the trade or roll to a new diagonal spread. Over a week ago, I could do this for an attractive price. At this point, the price isn't as attractive but that's likely because volatility is up.

Update 5/12/2010 (closing update)

Ok frankly, I probably deserve to have had this trade be a loser. This is the kind of situation where I should have gotten out when I had a chance and didn't. A week later, I almost had this trade become a loser. Thankfully the market rallied back enough that I was able to get out with a decent closing price.

A friend reminded me that there's nothing wrong with taking a profit. That's a good philosophy as long as taking profit doesn't mean picking up a few pennies on every trade. Sometimes it's good to have a reminder like this event.

Now that the trade is closed, let's take a look at the trade. I entered the trade originally with a debit of $5.76. I executed my first roll for a $.51, which was a straight across roll. Next, I rolled from the April $66 to the May $67 call for a $.10 credit. Finally, I closed the trade for a credit of $7.68 credit. All of that together makes a net profit of $2.53. That makes my ROI 44% and a 1.3% on my initial portfolio amount. Not bad overall for a trade that lasted just over 2 months.

I had talked about the possibility of entering another diagonal spread. However, this market seems just a little too turbulent to consider that just yet. That's the main reason I decided to close the position rather than rolling into a new diagonal spread.

Rule # 1 - Don't lose money.
Rule # 2 - Never forget Rule #1  (Warren Buffet)

Note: This trade discussion is for educational purposes only. I am NOT making any recommendations on the trade or the underlying stock or ETF. If you decide to follow this trade, please do so in a paper trading account. Trading options involves risk and some options strategies can result in losing more than the original amount invested.

thinkorswim, Division of TD Ameritrade, Inc. and Success With Options are separate, unaffiliated companies and are not responsible for each other's services and products.

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