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Trade Tutorial - Call Diagonal Spread (3/28/2011)

I'm taking another shot at this diagonal spread on GLD.

diagonal spread trade on GLD

Buy GLD May/Apr 134/141 diagonal spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.05)
2. Exit if cost to close >= twice initial credit (i.e. $1.15)
3. Exit if within 4-7 days of expiration
Debit $5.24

I've been waiting for another opportunity to re-enter this trade on the GLD ETF, which represents actual gold shares. I missed the first chance several weeks ago but this might be almost as good.

Why this strategy?

The GLD has been on a nice bullish trend for the last few months. However, there was a pretty decent sell-off about a month ago that stopped me out of the trade I had going at the time. I really liked how the pull-back settled right at about the 30 day moving average before resuming the up trend, even to the point of creating a temporary high. This morning the ETF gapped down to the the 30 day MA before rallying up.

As I felt before, the GLD will likely be in a longer term bullish trend, which makes the diagonal spread a great strategy to employ.

Choosing the right strike prices

The trading plan I use for diagonal spreads calls for selecting a long strike several months out having a delta of around .7 and a short strike with at least 20 days until expiration and having a delta of around .3. In order to keep the cost of the trade lower, I selected a May option month for the long strike.

diagonal spread strike selection

This is a $7 wide spread costing $5.24 to enter. That means if the trade reaches its full potential, I could realize a profit of $1.76.

Risk/Reward analysis

There are several ways to evaluate this trade. At first consideration, we have a trade that could return $1.76 on an investment of $5.24. That would be an ROI of 33%.

On the other hand, consider that a diagonal spread is a combination of a calendar spread and a vertical spread. That means this trade has one roll built into it, which can be accomplished for a credit. Let's do a quick analysis to see what that potential roll would be.

diagonal spread trade analysis

We can do this by using the theoretical price. When we select this as one of the columns, several additional fields become available. We can use these to calculate the roll value at a future point of time. Here's what I did.

  1. Change the spread type to 'Calendar', which will display combinations of options months as calendar spreads.
  2. Increase the stock price by $2, which will bring it to within $1 of the target short strike.
  3. Roll the date forward to a week before expiration.
  4. The theoretical price represents the anticipated price given these conditions on the targeted date.

It looks like if we anticipate the GLD moving up $2 in the next few weeks, I could roll the short strike into a May vertical spread for an additional $1.71 credit. That means the trade could yield a 66% ROI. That's a lot better return.

It is possible that this trade could ultimately be rolled into another diagonal spread. If this happens, the trade could be even more profitable. For the sake of demonstrating this longer term management, I'm hoping this will work out.

Position sizing

Here's the thing about this trade. The cost to enter this trade is $5.24, which means I'll have to spend $524 and potentially put this amount at risk. The only way to manage this is to close the trade out early to limit loss. Let's look at what needs to happen.

I need to make sure I limit the risk to just 2% of my current portfolio value, which is currently $17,586. That means I could risk $351 on this trade. Given this, I can allow the trade to potentially lose over 1/2 its value before being forced to close it.

Exit plan

In order to ensure this trade loses no more than $351 in value, I need to make sure that I exit this trade with a debit stop loss of $1.73 (5.24 - 3.51). This will make sure the trade loses no more than is tolerable.

I will also be looking for an opportunity to roll the short strike from April to May for a reasonable credit. I'd like target at least being able to roll for at least $1.60.

To summarize, I will exit under the following conditions.

  1. I will exit when the value of the position drops to just $1.73 (limiting my loss to just $3.51).
  2. I will roll the short strike when within 4-5 days of April expiration or if I can do so for at least $1.60.
  3. I will exit when approximately 4-5 days of expiration.

Portfolio Impact

A diagonal spread trade such as this is expected to add positive delta, positive theta and negative vega. The positive vega means that I could expect an increase in value with an increase in volatility. This isn't typical when the underlying is moving up but a slight sell-off accompanied by a passage of time could actually benefit this trade.

diagonal spread portfolio impact

Note that these components compliment the portfolio by making it more delta neutral while adding positive theta and making the overall portfolio less susceptible to changes in volatility.

Update 4/11/2011

Ok, so here we are at the last week of the short strike's option expiration cycle. My rule is typically to look for a good roll opportunity within the last 4-5 days prior to expiration. I'd also look for a roll any time I could get a good roll price.

As it stands, the GLD is currently about $2 higher than the short strike at about $143. The ideal roll scenario would be if the GLD was right at $141 or a little below. However it looks like GLD is heading for a continued bullish move. That said, I have several things to think about when considering my roll.

I could roll from April $141 to May $141 short strike (leaving a $7 wide vertical spread) for an additional $1.49 credit. However, given the apparent bullishness of GLD, I may want to also consider rolling up at least another $1 in the spread. For example, I could roll to a May $142 for $.88 credit. So I'm giving up about $.60 in additional credit to buy another $1 in the width of the strike. I could roll to a May $143 for $.34 credit, which gives me a $9 wide spread but I give up an additional $.54.

Which strike price should I roll to? It really depends on how bullish I am on GLD over the next month. If I was really bullish, I'd go for the $143 roll and settle for much less credit up front for the larger payoff down the road. If I was less bullish or even thought GLD might pull back some, I'd simply roll straight across and take the full credit up front.

For the purposes of this tutorial, I think I'll go with the "middle of the road" solution by rolling up $1 on the strike and picking up an additional $.88 in credit. How will this affect my trade? My maximum loss will now only be $4.36 if the worst case scenario occurred. On the other hand, my spread is now $8 wide with a $4.36 cost basis. That means that my new potential profit would be $3.64, which would be an ROI of 83%.

The only thing I need to happen in order for the best case scenario to result is that GLD remains above $142 by May expiration. If it is well above that level by the last week before expiration, I should be able to close the spread for very close to $8 credit.

Update 4/29/2011

This diagonal spread trade has reached a point where it's time to take some sort of action. When last we left the position, it had been rolled into a $8 wide long vertical spread. The next logical step would be to close the position for as near to $8 credit as possible.

On the other hand, I have hinted a number of times that I had other plans for this position. There are a number of ways to manage a diagonal spread that has reached this stage. The obvious next step is to close the trade and reap the profit. However, another way to manage this position is to roll it into a brand new position.

As this order above shows, what I'm suggesting is rolling the May $142/134 vertical spread into a May/June $155/147 diagonal spread. What I've done is select options that fit the rules of a new diagonal spread. What I found was a June $147 long call having a delta of .71 and a May $155 short call having a delta of .35. The net result of rolling this trade is a credit of $2.00 (I didn't quite get the $2.01 shown above on the actual fill).

Notice that while this is still an $8 wide spread, the entire position has moved up. I'm now in an $8 wide diagonal spread with one roll build into it that has a net cost of $2.36. Remember, before this trade my cost basis in the trade was $4.36. With the $2.00 credit for rolling, I have a potential $8 gain for a cost of $2.36. I'm now looking at an ROI of 338%. Yes, that's right.

Of course, there are several things to consider here. First, I could have simply closed the trade, locked in the profit and been done with it. Instead, I've deferred the profit by rolling the trade and only taking a partial credit. In addition, I have a trade that still could go bad on me. In essense what I'm doing is trading a 'bird in the hand for two in the bush'. I am rolling into a new trade with the chance that it might return an even nicer return.

I can't leave this discussion without pointing out that this trade is really no different then closing out the original trade for $7.90 (the going rate when I looked at exiting) and entering a new diagonal spread with the parameters listed above for a debit of $5.90 (the going rate of the new trade). This would yield a profit of $2.10 and an ROI of 35%. So the trade makes sense all by itself.

This roll provides an opportunity to continue on with a trade on an underlying that appears to have plenty more steam. We'll continue to monitor the trade as it develops.

Update 5/4/2011

Ok, so it figures that right after I rolled the trade, GLD started selling off. So far, that's not that worrisome as long as we don't see a break of support around $147.50. Notice we're pretty close right now.

That said, I'm closing the short call, which dropped in value to $.35. That leaves me with a June long $147 call. I'll be watching to see what happens with GLD from here. If GLD closes below $147.50, I'm going to close the long call as well. Why not close the whole thing right now? The way I see it, I could have but then missed the a potential rally if this selling is short-lived. By waiting, I may risk a little more on the trade but leave room to benefit a bounce.

If the rally does resume, I'm now long GLD by way of an option. I'll then wait for an opportunity to possibly sell a short call to maybe pick up a little extra credit.


Update 5/24/2011 (closing update)

So I just realized I neglected to post an update regarding the ultimate close of this diagonal spread trade. The trade was actually closed on 5/11 and I'm just now getting the final update out.

First, I have to confess that I let this trade go just a little too long. I really should have been out of this trade a few days earlier and would have done a lot better on this trade. More on this later. I was able to close the long call for a credit of $2.88. At the end of the day, all I made on the trade was $15. However, it wasn't a loss!

The sad part of this trade is that I had a good profit in this trade prior to rolling into the new position. On one hand this could have turned into a really decent profit but it also could have turned into a nasty loss if I hadn't closed when I did. The big lesson here is to have clear plans for exit and stick with them. I should have probably closed this trade earlier (shortly after buying back the short strike) as it could have gone badly for me. Fortunately a rally gave me a chance to get out of the trade with a a small gain. Now that we're more than a week past the date I executed the closing trade, it is now 'obvious' that had I stayed in, I might have done better but you never know that when looking at the hard right edge of the chart.

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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