Trade of the Week - Diagonal Spread (8/25/2009)

I've been looking for an opportunity to put on a diagonal spread. Not just because it's the first one in the 'trade of the week' series, but because I was looking to put on a longer term bullish position.

Diagonal Spread trade of the week

As this chart illustrates, SMH has been in a pretty steady up trend. With a recent pullback to the moving average, it is beginning to move up again. The only risk I see in this trade is that SMH fails to break above previous highs.

Trade
SMH Diagonal Spread Nov/Sept 22/26 calls
ROI
 24%
Exits
1. On a close below $23.80 coupled with failure to break $25.50
2. Roll short strike with 5-7 days to expiration
3. Close final spread 5-7 days prior to expiration
Debit $3.23

Why this strategy?

As I mentioned, I'm looking for a longer term bullish position. In other trades, I currently have a bearish position that isn't doing too well, a neutral position that recently became bearish when I closed the put spread, and another bullish position that is doing pretty well. If the bullish trend continues for some time, this position will continue to do well.

I chose to trade this strategy on the SMH, which is an ETF of a collection semiconductor companies. Semiconductors have long been considered the leading indicator of the technology sector and often for the market as a whole. As such, SMH is a heavily traded ETF, which ensures that volume will be sufficiently high.

Choosing the right strike prices

I mentioned in my diagonal spread strategy page some rules for choosing both the long and short positions. For the long put, I want to be at least 60 days out in time and have a delta of .7-.8. For the short position, I want to have at least 20 days left and a delta of around .25-.3. As a result, I've selected the following positions.

Diagonal spread trade setup

With a long November position, I'll have the ability to roll the short position 2 times, leaving me with a long call vertical spread in November. Notice also that the above positions has a high open interest. This is important for getting a good fill price.

Position sizing and profit analysis

Here, I've set the order up to purchase the November 22 call while simultaneously selling the September 26 call for a net credit of $3.21. I've indicated on the picture below that the spread is $4. That means on the up side, if SMH was to make a strong move in the next few weeks and power through the upper strike, I'd make about $.80, which is a 20% ROI. The goal is to do better than this. As I roll forward to future months and potentially up to higher strike prices, I can widen out the profit potential.

Diagonal Spread trade setup

Since I put a diagonal spread on for a debit, my maximum loss would be the amount I paid to enter the spread. As per my usual trading rules, I'm risking about 2% of my portfolio. With all my trades on right now, it's difficult to determine my actual portfolio size. My net liquidating value is around $20,000. That would mean risking around $400. Since this trade will cost me $321 to enter, I'll only take one contract. Note: I actually ended up paying $3.23 to fill this position.

Exit plan

The diagonal spread is a longer term position. The key thing that would make me want to exit this trade early is if SMH fails to break above the previous highs of around $25.50. Failure do do so would indicate a potential double top, a significant reversal pattern. However, I wouldn't consider exiting unless the support level of $24 was broken. Beyond that, I would simply wait for opportunity to roll the short strike forward. With that, here are my exit rules.

  1. Exit on close below $23.80 coupled with a failure to break above $25.50
  2. Roll the short strike 5-7 days prior to short strike expiration
  3. Look to close the long position 5-7 days prior to expiration

This is a longer term trade and as such will require a fair amount of patience. As with my other positions, this is a positive theta (time decay) position so it will make some amount of money even if the market goes nowhere. However, it is a more bullish position than many of the positions I have put on so I'm really looking for SMH to make a stronger bullish move to be more profitable.

Update 9/3/09

SMH got some help from Intel's announcement last Friday that they were raising their third quarter earnings guidance. However, that didn't last long as the markets have sold off this week. Is this trade in danger?

diagonal spread trade in progress

Not necessarily. The first thing I want to point out is that the diagonal spread is a medium term trade (i.e. 2-3 months). This trade needs to be evaluated in that context. Notice that SMH is still in an up trend. However, there are signs that the market overall is pulling back and may be set up for a slight correction.

What are my potential responses if this happens?

  1. I have an exit rule in place that says exit if SMH closes below 23.80. That's the prior low and to close below that would result in a break of support and lower low.
  2. Look for an opportunity to buy back my short call and wait for another move up to sell the next month at either the same strike (26) or higher.
  3. Consider rolling down my short strike to pick up more premium and decrease my risk/cost basis in the trade

It's possible that the pullback may continue but a support bounce at 24 or so may occur. In this case, there would be an opportunity to buy back my short call. With diagonal spreads, unlike calendar spreads, it isn't always necessary to accomplish the roll in one trade. This style of trading is a little more like a covered call spread. I want to be selling the short strike when oscillating indicators (Stochastic and MACD) indicate more of an over bought condition and buy back the short position when in an over sold condition.

One of the things I love about using these trade of the week pages to capture my trades is it allows me to think out loud about my trades and plan my actions more thoroughly than I would if I was just doing a paper journal. I hope this process is helpful to others as well.

Update 9/14/2009

I waited for this update expecting to maybe roll this trade on Friday.  However, I was expecting to see more time value melt away. I am now within the 4-7 day window and I think it's time to roll regardless.

Diagonal Spread roll example

I was able to roll from September to October for $.55. How does this affect my position? By selling this roll for $.55, I've lowered my cost basis in this diagonal spread trade  from $3.23 to $2.68. What this means is that if SMH continues to move up above $26 and closes there, my profit in the trade will be $1.32. Remember, the vertical spread component of this trade is $4. The less this spread costs me in the end, the more of this $4 I get to keep.

So, what now? It's time to wait some more. What I have now is a one month diagonal spread. There will be another opportunity to roll from October to November to form a long vertical spread. However, this opportunity probably won't be available for several more weeks. In the mean time, what could happen to SMH... and what might my responses be?

SMH could make a strong move up to $27 as it nearly did last week. In fact it might move even higher. In this case, there may be an opportunity to roll not only from October to November but also from the short $26 to the short $27. I've talked about this earlier as a possible action. While I may not take as much in credit, I will be widening the vertical spread to $5.

The other possibility is that SMH could begin a pullback. As I mentioned earlier, there may be an opportunity to buy back the short October and wait for an opportunity to re-sell the October or November.

It's too early to take any action but never to early to plan my next possible moves.

Update 9/21/2009

Not much to report. I'm a week into the second month's roll for this diagonal spread so there's still a lot of time left to melt away. SMH hasn't really gone anywhere (currently trading at just over $25) so I'm not at a risk of being assigned.

The plans I listed for possible exits are still in place. My cost basis is now $2.68 and I could close to the trade for $3.11 so the trade is currently in profit by $.43, which is a 16% profit. However, given I'm not at any of my exit targets, I'll just continue to monitor and let time melt away on the short strike.

Update 9/29/2009

Even with the sell off last week, the rally yesterday allowed SMH to penetrate the short strike briefly. That's actually a good thing!

While I was pondering whether it was getting close to time for closing this diagonal spread trade, something occurred to me that I want to go through here.

My current cost basis in the trade is $2.68 since i rolled the first month for $.55. I could close the trade right now for $3.44, which is a gain of $.76 and an ROI of 21%. That's one possible way to handle this trade. However, if I wait another few weeks and SMH continues to move up, I could probably close the trade for closer to $4, which is the spread between the strikes.

On the other hand, I could roll the short strike from October to November, creating a long vertical spread $4 wide. Today, I could do this for around $.50. That would lower my cost basis to around $2.18. If, a month from now, SMH was approximately where it is now and I closed the trade for about the same price ($3.44), I would now have a gain of $1.26 - an ROI of 35%.

The thing to keep in mind here is that these two choices aren't equal. The first choice and its outcome are based on present value - it's what I could get right this minute to close the trade.

The second choice is based partially on what COULD happen. It assumes that SMH remains approximately where it is or goes higher. If the market sells off strongly -  a definite possibility - then this analysis goes out the window,

The challenge we are always faced with as traders is whether to take the current profit and run or risk it for a potentially higher gain. If not for trading rules, this would probably create a fair amount of turmoil inside of me.

I'm about a week away from considering a roll unless the roll value goes up to around $.55. So I'll continue to wait and watch for an opportunity to roll or close. Diagonal spread trades are fun right?

Update 10/6/2009

This diagonal spread trade has been fascinating for me to watch unfold. SMH has been up, it's been down and the trade is still doing well. I was actually considering an exit yesterday when it looked like the market might sell off further. 

Here's where this position currently stands.

Diagonal spread position analysis

As of today, I could close the trade for $3.09. A profitable trade if only by just a small amount. However, look at where SMH is relative to where it was when I put the trade on. It's actually lower and yet I'm making a profit. That's the power of the calendar spread component of this diagonal spread. Remember, a diagonal spread is a combination of a calendar spread and a vertical spread.

With just under two weeks to go until October expiration, if SMH gets anywhere near $26, I'll be able to execute the roll to November for a nice credit. However, I talked last week about the trade off between rolling and waiting for the best possible outcome versus simply closing the trade for a smaller profit. That evaluation will be done and I may simply close the trade altogether if I can lock in a nice profit and/or the market outlook remains fairly bullish.

Update 10/9/2009

I ended up closing this trade a lot sooner than I planned. I sold the entire diagonal spread back for a credit of $3.54. There are several ways to calculate the total gain on this trade, but let's do it this way. I originally purchased this spread for $3.23. About a month ago, I executed a roll that brought in a $.55 credit and then I closed to day for an additional $3.54. So my initial debit was $3.54 and my total credit is $4.09 leaving a net profit of $.86. My ROI is the $.86 net profit divided by my initial debit of $3.54 or 24%.

This trade could have yielded a better return had I left it on, however one key thing to remember is what I talked about just over a week ago. I may have been able to simply roll this short October $26 strike to November and collect another $.60, which I considered. However, I don't know what the remainder of October and into November will look like and I wasn't willing to risk the profit in this trade. A 24% return in just over a month's time isn't too bad in my opinion.

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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