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Trade Tutorial - Call Diagonal Spread (7/29/2010)

I haven't done a diagonal spread in a little while so I thought now would be a good time to do one. I've waited a little bit before entering another trade just because the market wasn't rushing to tip its hand. A few days ago, it seems the market did just that.

diagonal spread on the IWM

Buy IWM Sep4/Aug 57/67 call spread
1. Exit if I can lock in 40% return on of my initial debit
2. Exit if the value of the position drops to below 1/2 initial value ($3.87)
3. Roll 4-5 days to expiration or if I can receive $1 on the roll
4. Exit if within 4-7 days of expiration
Debit $7.74

This is a shorter term diagonal spread. I usually look to to this trade over several months. I'll be talking more about my rationale a little later.

Why this strategy?

Obviously the most recent move by IWM makes me a little more bullish. What we have is a higher low and a higher high. Until the last few days of selling I was thinking perhaps I missed the entry but that has changed.

The thing I noticed as I was looking at the various broad market ETFs (SPY, DIA, IWM, etc) is the relative strength displayed by the IWM. If this strength continues it would be more appropriate to consider a bullish diagonal spread rather than a more fixed gain strategy like the put credit spread.

I will continue to be bullish on IWM as long as it stays above about 64. If IWM falls below 64, we'll be entering into a yellow alert condition that may call for trade management or exiting all together.

Choosing the right strike prices

Since I haven't covered a lot of diagonal spread trades, I want to take a little time to talk about strike selection because this is a key aspect of this strategy. There are a lot of ways a diagonal spread can be created, however my trading plan calls for a specific set of rules in the strike selection for both the long and short option.

For the long strike, I usually look for an option several months out in time. Since I wanted a little shorter term position AND because the next available option month is November, I went with September quarterly options. I look for a call having a delta of between .75 and .8. The image capture above shows a delta of .79 but it was actually more like .81 when I set the trade up.

For the short strike, I look for closest option month that still has 20 days  until expiration. I captured this today but entered the trade yesterday when there were still 22 days left. I look for a short strike having a delta of between .25 and .30. When I entered the trade, the delta was closer to .26.

The result is a $10 wide spread with 2 rolls at a cost of $7.74. That means there's a potential built in profit of $2.26 for a 29% ROI. That assumes that IWM moves up so rapidly that I get no rolls and am forced to close the spread for the difference between the long and short strike.

Risk/Reward analysis

Speaking of calculating the target reward, let's consider a few different scenarios. The first one I already outlined assumes that IWM will move well above the $68 short strike and I'm able to close the spread for a credit of $10.

The second scenario assumes I have a chance to perform at least one roll.

diagonal spread roll analysis

To do this analysis, I switched the option chain view to show calendar spreads. I then set one of the display columns to 'Theo price'. I'm going to do this analysis assuming we move forward 2 weeks and IWM moves up $2 to $67.

A probable roll value for this position would be for a $1.26 credit. That would mean my cost basis in the trade is now $7.74 - $1.26 = $6.48. If I assumed the same situation where IWM moved well above and I closed the trade in September for $10 credit, my profit is now $3.52, which makes my ROI 45% if I use my initial debit as the risk amount. That's a pretty decent return.

I could potentially perform an additional roll from September to September quarterly to create a long vertical spread. That would reduce my cost basis even more and make this an even more profitable trade. I'd consider this a pretty successful trade if I was able to realize the 45% ROI.

Position sizing

Position sizing for the diagonal spread gets a little bit tricky. For one thing, the initial cost of the position is quite a bit higher that an some of the other strategies I employ. In this case, the cost of 1 contract is $7.74. If I assumed that was the risk in the trade, I wouldn't be able to take the trade.

On the other hand, if I used an exit strategy where I closed the trade if the position lost 1/2 its value, then my risk in the trade would only be $387. That's still a little high but manageable. Especially since I will be adding an early exit technical rule.

My current portfolio stands at $18,214, which means 2% would be about $364. So I would be risking slightly more than 2% on this trade if I exited if the spread lost 1/2 its value. For this trade, I'm going to buy just 1 contract and manage the risk with several exit rules.

Exit plan

For my diagonal spread strategy, I will be implementing several exit and roll rules that are based on my trading plan.

  1. I will roll the position when I'm within 4-5 days of expiration or when I can do so for at least $1 credit
  2. I will close the position if I can lock in 40% return on my original risk
  3. I will exit the trade entirely if the position value drops to below 1/2 the original debit or $3.87
  4. I will exit when approximately 4-5 days of expiration

Portfolio Impact

Prior to entering this trade, I had an iron condor trade on and a short call vertical spread. With the market move up, my portfolio delta was becoming more negative than I would prefer given my more bullish stance.

diagonal spread portfolio impact

With the diagonal spread in place, my overall position delta is a little more balanced. It's not completely neutral but less negative than before. It's well within my range of tolerance given my cautiously bullish stance. Assuming the bullishness continues, I'll look at putting on more bullish trades next week.

Update 8/18/2010

With the selling last week, I simply closed the short call for .05. This trade has entered into a state where I'll be watching to see if it just makes sense to close the position since my initial assessment may be wrong.

I said one of my exit rules was if the value of the position drops to 1/2 the initial debit. That means I'll be looking for an exit at around $3.87. The thing to keep in mind is that the diagonal spread is a medium term strategy and that requires a little more patience than shorter term trades.

While I currently hold just a naked long position, I won't be looking to add a short call to the position until IWM has recovered some of its price. Ideally, I'd be able to sell a Sept 67 call and then roll it to the Sept quarterly to form a vertical spread.


Update 8/29/2010 (closing update)

I was forced to close this position based on my rules for a $3.87 credit, which was 1/2 the original debit to enter this diagonal spread trade. That means this lost $387 since I only had one contract open.

I've mentioned in the recent updates of the various trades I have open how challenging this market is to trade. Short of not trading, is there anything that can be done to improve the results? This trade had no technical rule for an exit. In retrospect, there probably was a point back in early August when the IWM broke through support levels of all the moving averages I use.

While I've been following more of a 'set it and forget it' model lately, I believe this market is too volatile for that. If the past few months have shown us anything, it's that you have to constantly monitor the trend and the trades that are based on it. This has to be balanced with a tendency (based out of fear) of acting too soon.

I'll be entering some new trades soon that will include a technical component to the exit rules. Hopefully, we'll get a chance to see how that affects trades going forward.

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

Stay tuned for further updates as the trade progresses...

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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