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Trade Tutorial - Call Diagonal Spread (10/20/2010)

Given my overall bullishness, I've been looking for a nice diagonal spread to enter. Earlier this week I considered a trade on the SPY but that was too expensive for my portfolio.

Diagonal spread on the EWZ

Buy EWZ  call Dec 71/Nov 82 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 $7.76

Why this strategy?

I'm re-considering this strategy because I think we're heading into a period of extended bullishness. I don't think it will be straight up necessarily but I believe the trend into the end of the year is looking more bullish.

As I've mentioned in last trade tutorial page, there are a number of strategies I could employ when bullish including a long call, a long call vertical spread or short put vertical spread, a call calendar spread. The reason I'm going with the diagonal spread is because it has the characteristic of being more long term focused than a vertical spread. The spread I'm considering is a Dec/Nov spread, which means that this trade will potentially be in play until mid Dec.

In addition, it has the potential to be a much longer term trade if bullishness continues into 2011. I won't talk much more about this aspect here but will at a future point as we reach the end of the existing trade.

Choosing the right strike prices

The trading plan I have for the diagonal spread calls for buying a long call 2-3 months out with a delta of between .7 and .8. For the short call, I'm looking for an option with at least 20 days until expiration and a delta of around .3.

diagonal spread strike selection

In this case, I found a long $71 call in the December option cycle with a delta of about .78 and a short $82 call in the November option cycle with a delta of about .30. This will give me a $11 wide spread at an entry cost of about $7.76. If you think about it, this is a great price if we have an expectation of EWZ exceeding $82 by December.

Risk/Reward analysis

Let's take a moment to consider the reward vs. risk in this trade. The risk is know in this case. It's the cost of the trade ($7.76 per contract). On the surface, the reward would appear to be the width of the spread minus the cost of entry. That would be $3.24 ($11 - $7.76). So the reward/risk ratio would be 41%. This percentage could also be considered the return on risk.

At this point, I've only considered the vertical spread component of this diagonal spread. There is also a calendar spread component that will allow me to pick up additional credit on the roll. This component is a little more difficult to calculate because there are so many factors to consider, including expected price of the underlying on the roll, date of roll, volatility, etc.

To keep this simple, let's say that EWZ is at $80 in the last week of November's expiration cycle and we decide to roll. I can calculate the value of the roll using thinkorswim's theoretical price feature on the trade tab.

diagonal spread trade analysis

Here we've adjusted all the settings and it looks like we could potentially pick up an additional $1.48 in the roll. That would make my expected reward $4.72 with a risk of $7.76. That's an ROI of 60%.

Does that sound interesting enough?

Position sizing

Here's the problem I have in the current trade as discussed so far. My maximum trade risk can only be 2% of my portfolio which is currently $344. However one contract would cost me $7.76. With no trade management plan in place, I am looking at closer to 5% risk on my portfolio. However, what if I had an exit rule to close the trade if the value of the diagonal spread dropped by $344?

In order to do so, I would need a stop order in place. What this means is that I can buy 1 contract of this spread for $776 but have a stop loss order in that would close if the price dropped to $4.32. That would allow me to take this position and still remain within my portfolio risk parameters.

Exit plan/Trade Management

Managing a diagonal spread is a little trickier than other strategies like vertical spreads. Due to the calendar spread component of this trade there is a roll that will typically get executed at some point.

On the diagonal spread strategy page, I talk about a couple of scenarios that I want to employ here. The first scenario is to close the short position if the price is less than $.10. The reason for this is is that once most of the premium has drained out of the short position, it doesn't make much sense to hold on to it. Buying back the short option leaves a long position that I can then sell another short option at a future time - hopefully for a better price than a simple roll.

That brings me to the second scenario. Instead of buying back the short call, I might simply roll the short call to the next month buy simultaneously buying in the short strike in the current month and selling a new call in the next month. This call could be the same strike or one farther OTM if I'm more bullish. Obviously if I can get a decent price on the roll, this is a better choice than simply buying back the short strike.

My rule of thumb is that if I can execute the roll for about 20% of the initial debit, I'll prefer to do that.

With the above rules for managing rolls and my exit rule to limit loss I have one more rule for exiting. That is to close the entire trade when there are only 4-5 days until expiration.

So here then are my basic rules for managing this trade

  1. I will exit the trade if the value of the position drops to $4.32 - this limits my loss to $344.
  2. I will roll the position if I can do so for at least 20% of the initial debit.
  3. I will close the short strike if I can do so for $.10 or less and look for a better opportunity to sell the short strike again.
  4. I will exit when approximately 4-5 days of expiration

Portfolio Impact

This is the third bullish trade I've entered in the last few weeks. As a result, it's no surprise that the impact of this trade is to add more positive delta.

diagonal spread portfolio impact

However, the other benefit of this trade is the positive theta I receive with time simply passing by. I doubt I will be entering any additional bullish trades.

Update 11/14/2010

It is soon time to consider rolling the short strike to December... or consider closing the trade. The EWZ has not been as bullish as I had hoped. The outcome of the next few days will determine what course I take.

I did not include an exit for the situation where the underlying does not move as expected or in the timeframe expected. However, it is perfectly acceptable to close a tread early if trade conditions dictate it.

diagonal spread trade evaluation

Consider the recent behavior of the EWZ. We have what appears to be a double top and the EWZ currently is sitting at a support level. If this support is broken then it is clear this trade is no longer valid for the conditions and I will simply close the position. If another bounce results in the next day or so, then I will roll the short strike but monitor this position closely.

Update 11/20/2010

I ended up going for a third option. Initially I considered my options as rolling or closing. Third choice is closing the short call and waiting for a new entry.

Why take this third choice? As I look at the remainder of the market, I'm still bullish. While I may regret this choice, I believe there is still some up side going into the end of the year and the overall market technical indicators support this (so far).

To be more clear, this third choice involved buying back the short strike, which I did on Wednesday for $.02. I'm now left with a long $71 call that is currently worth $7.20. That means the overall position has only lost $.58 (counting the $.02 I paid to close the short call). If the rally continues, I'll for an opportunity to sell the December $82 or higher call option. This will change the position from a negative theta to a positive theta position. I still have my stop order in place to protect my risk.

Why not go with my initial decision to use a technical exit to save capital? That's a difficult question to answer. To be honest, part of reason was that I want this trade to be a winner and exiting now would make it a losing trade. That said, it would have been foolish not to have taken the exit if I was facing the max allowable loss on the trade. I felt that since I was not at that point yet, I had some latitude in my decision. This was especially true given my broader market analysis. This may ultimately prove to be a failed trend but that hasn't happened yet.


Update 11/23/2010

Well, the worst case actually happened. The turbulence of the last few days has shaken me out of this diagonal spread position. I'm kind of angry about this because my stop forced me out of the trade before it could turn around. Unfortunately that's the down side of having a stop loss order on a trade that may well run the gambit.

In this case, my portfolio was small enough that the only way to enter even one contract of a diagonal spread was the stop loss. However, I really want this trade to play out so I can demonstrate some of the other trade management approaches.

Since I did have a stop loss in place, I'm going to go ahead and take my lumps but I'm also going to play a little 'what if?'. I entered this position for a debit of $7.76. I closed the short call for $.02 and sold back the long call for $4.40. That means the net loss for this position $3.34 per contract or $334.

I'm going to re-enter this position off the books so to speak. The initial position is a loss. However, I want to leave the trade running so I can play it out. There is still a chance that this will be a full loss but since we've already logged this trade as a loss I want to let it play out. This won't be the full diagonal spread, but just the long call.

As a bonus, it may give us an opportunity to explore both the case where I used a stop loss and one where the trade plays out fully. My expectation is that with more of a rally, I'll sell the December call and then manage it on forward.

Update 12/18/2010

The December options expire this weekend, which means the long call I'm holding will get exercised since it's in the money. As a reminder, this long call is the remainder of the diagonal spread I entered way back in October. Keep in mind the initial diagonal spread trade closed about a month ago and is analyzed above. I'm playing the 'what if' game on this trade to see how it plays out.

Here's where this trade stands at the moment. I'm holding a $71 call but closing price of EWZ as of yesterday was 75.69. That means if I closed the position Monday morning for the same price I would realize a gross profit of $4.70. However I originally paid $7.76 for the position and paid $.02 to close the short call. That means that if I closed the position Monday morning the net loss would only be $3.04. So far this is slightly better than how the initial trade played out.

Believe it or not this trade is still not complete. What happens Saturday at noon is that I'll be assigned 100 shares of EWZ at $71, which means I'll have to pay an additional $7,100 to stay in the game. But how will we handle this trade now?

What I'm going to do is enter a stop loss order that will basically ensure this trade doesn't lose any more than the alternate route I took a month ago where I closed with a stop loss. At this point the position can only lose $30 to reach the point where it is equal to the loss of the first trade scenario.

As a result, I will enter a stop loss order to close the trade if the price of EWZ drops to $75.39. For now, I'll let the trade run for a little while longer. As I mentioned in the prior trade update, I want to use this trade to illustrate longer term trade management. Had my portfolio been large enough to justify it, I would have simply let the trade run as I'm doing here (off the books so to speak). That's the beauty of virtual trading accounts.

Before closing, I want to take a moment to project this trade forward into the future. We already know the worst case scenario, which is that the stop loss triggers and will lose the same amount as the initial trade. However, EWZ will need to gain $3.04 just to break even. From there, anything above a $3.04 gain is profit.

My initial target profit was $3.24. In order for that to happen I'll need EWZ to reach about $82. That's not out of the realm of possibility but right now EWZ has been a bit depressed as we've experienced dollar strengthening and overall market malaise. This may remain the case into the end of the year. However if I can exit this position at around $82, I'll consider this second scenario a success.

Update 12/20/2010 (Final Update)

Well, it's finally time to pull the plug on this trade. Over the weekend I was assigned and was left holding 100 shares of EWZ at $71. I said in the last update that I would institute a stop loss order to make sure I don't lose any more with this approach than with the initial trade.

I really had hoped this would turn out differently so that I could demonstrate some of the different management strategies. For example, one technique I might have employed once the EWZ had gained in value by a few more dollars is to sell a call, which would be very similar to the original diagonal spread I had.

I want to conclude this entry with a reminder that this outcome is a possible risk in any trade. I had hoped that by playing the other side of the the trade (by staying in) that I'd be able to explore the benefits of being able to 'stay the course'. Unfortunately no trade comes with a guarantee, which is why money management is so critical.

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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