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Trade Tutorial - Call Diagonal Spread (9/14/2011)

It seems like a good time to enter a long diagonal spread. This is a bit more of a longer term trade. Follow along as I set this trade up.

Diagonal Spread Trade setup

Sell SPY Nov/Oct $112/124 call spread
1. Roll the short strike if within 4-5 days of expiration
2. Close the trade if value of spread drops to $5.32
3. Exit if within 4-7 days of expiration
Debit $8.68

Why now? This week is option expiraiton week and the prior trade has closed. It seems like a good time to enter a new trade. In addition, the markety may be in the process of tipping its hand.

Why this strategy?

What direction has the tipped its hand toward? The SPY has been in a fairly wide range (almost $10) for the last month or so. However, in the process it has been established higher lows. A few weeks back, it established a higher high. It looks like we may soon see a new higher high established. 

This leads me to be a bit more bullish and for a longer period of time. As a result I'm lookng at a diagonal spread trade, which is not only a bullish trade but tends to play out over a time period of 4-6 weeks.

Choosing the right strike prices

With option expiration this week, the obvious choice of short strike month is October. This still leaves more than 30 days until expiration.

diagonal spread strike selection

I usually like to start with the short strike and work toward my long strike. With a short strike in the October expiration month, I want a delta of somewhere around .35. In selecting the long strike, I have several decisions to make. The first is how many months I want the trade to last, which will help me determine which option month to select for the back month (the long option month). 

For this trade, I want just a one month roll, so that means the long strike will be in November. I'll usually look for a long strike having a delta of around .7. This leaves me with a long November $112 and a short October $124, which is a $12 wide diagonal spread with the possibility of one roll.

Believe it or not, I was able to set this trade up for a debit of only $8.72. This means I have a potential of making a profit of $3.28 on this diagonal spread. 

Risk/Reward analysis

How did I arrive at a profit of $3.28. Remember that a diagonal spread is really a combination of a vertical spread and a calendar spread. As such, the vertical spread portion of this trade is $12 wide. That means if the October options expire with the SPY above $124, I could potentially close the spread for $12 credit. Since I paid $8.72 for the spread, my net profit would be $3.28. Using this approach, my return on risk would be 37%.

Let's look at this a little deeper. Remember, there is also a calendar spread component involved. That means I can potentially collect a credit for the roll, which would reduce my overall cost basis in the trade. How much could I get for the roll? This is the tricky part of the analysis. Here's the simple way to do this if you are using the thinkorswim platform.

diagonal spread roll analysis

I set up a 'what if' scenario where we roll forward to 1 week before expiration and assume nothing else changes. In this case, the roll value would be $1.93, which would make the cost basis in the trade $6.79 ($8.72 - $1.93). That would make my return on risk more like 76%.

Why the sudden jump? Two things have changed when calculating return on risk. The risk has been reduced to $6.79 while my return has increased to $5.21 (12 - $6.79). On the other hand, I might calculate my ROI (Return on Investment) as 5.21/8.72 = 59%.

Position sizing

On the surface, the fact that this diagonal spread costs $8.72 to enter might seem like a non-starter. However, as I've shown in past trades like this , the way to manage this is to have an absolute exit to limit loss to a tolerable amount. What is this amount?

My typical approach to position sizing is to limit my risk per trade to 2% of my portfolio value. At the moment, my account is about $17,000, which makes my tolerable risk about $340. Essentially then, I can allow my trade to lose $3.40 (or $340) before I exeed my risk limit. As a result, I will need to employ a hard stop loss to exit the trade if the value of the spread drops to $5.32 (8.72 - 3.40).

Actually, because I've limited my risk in this trade to just $3.40, that would affect my return on risk calculation. The good side of this is that my return on risk increases significantly. The downside is that my requirement to exit early means I may be forced to exit a trade only to have it potentially work out as desired. However, that's the chance I take in employing this technique. The nice thing is that I can do this objectively, not in the heat of emotion when my trade may be threatened.

Exit plan

I've mentioned several exit and rolling rules related to trade. Generally, the rules for a diagonal spread trade are a bit different.  There are af few absolute exit rules, which would include exiting to limit total loss or exiting to lock in a gain. There are also rules to define when to roll and how to roll.

To summarize, here are my trade management rules

  1.  I will exit the trade completely if the value of the spread drops to $5.32 (limits my max loss to $3.40)
  2. I will roll my short strike when it is within 4-5 days of expiration OR when I can do so for at least $1.90. I may consider instead rolling up to gain a wider strike position. 
  3. I will exit when approximately 4-5 days of expiration

Portfolio Impact

This trade is a longer term bullish, positive theta position. Since this is now the only trade I have running, it's not surprising to see my portfolio delta and my portfolio theta be positive.

diagonal spread portfolio impact

Notice that the delta and theta values very much reflect the fact that this trade has a long call vertical spread component to it. However, the fact that the vega is positive reflects the calendar spread component, which benefits from the increase in volatility.

Update 10/3/2011 (Closing Update)

This trade closed out Monday morning as the market was heading for fresh lows. In fact, it was beginning to look like the bottom was falling out of the market.

I always hate it when I have a trade that loses money. However, I hate it even more when I lose a lot of money. In this case, we limited the loss. Let's see how we did.

I entered the trade for a debit of $8.68. I closed the trade for a credit of $5.31, which means the trade lost $3.37 per contract. I bought just one contract so the loss on this trade is $337. As I started to say in this update, while I hate losing money, I hate losing a lot of money more. The nice thing about an exit rules I had in place is that it potentially saved me from a much larger loss.

Update 10/11/2011 (Post analysis)

A week after exiting this trade, it looks like the market may reverse once again. In retrospect one might be tempted to consider this early exit as a mistake. While it's still too early to tell, this trade may in fact have worked out as planned. Yet, you can't second guess every trade or exit rule just because one doesn't work out.

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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