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Trade Tutorial - Call Diagonal Spread (11/12/2010)

I'm entering another diagonal spread. This is a trade I'm excited about for a couple of reasons, which I'll talk about shortly.

Diagonal spread on GLD

Buy GLD Jan/Dec 126/138 call 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 $7.72

I've been looking for another longer term bullish position and also one that allowed me to take a trade on GLD, which is the ETF for gold.

Why this strategy?

I've been looking for an opportunity to enter a bullish trade on GLD for a couple of reasons. First of all, I expect the recent Fed policies to result in weakening dollar, which is bullish for gold and other commodities. In addition, GLD is in a bullish trend overall and this pullback has offered an opportunity to enter.

Another reason I'm excited about this particular trade as a tutorial is that I'm hoping for the opportunity to demonstrate one of the more interesting features of a diagonal spread. That's the ability to roll and build the trade beyond the initial life of the initial trade. I'll talk more about this later.

For the record, this is a long deep in the money diagonal spread that behaves similarly to a long call vertical spread. This is contrasted with a long out of the money variety, which behaves more like a short vertical spread with a time component to it.

Choosing the right strike prices

For the diagonal spread strategy, my rules for strike selection dictate choosing a long strike price several months out with a delta between .7 and .8. The short strike will be in a nearer month hand have a delta of around .3 with at least 20 days until expiration.

diagonal spread strike selection

With these parameters in mind, I ended up with a January $126 for my long strike and a December $138 short strike. This leaves me with a one month spread with a $12 spread. The cost of this spread is around $7.72.

Risk/Reward analysis

The analysis of this trade is a little bit complicated but a worthwhile endeavor as we'll see. Let's start with the simplest form of analysis. We have a spread that cost $7.72 to enter but is $12 wide. If this were simply a long vertical spread, the potential profit in the trade would be a simple calculation ($12 - $7.72 = $4.28). That means my potential ROI in this trade is a minimum of 55%.

From there, it gets even better. This trade has one roll built into it. This roll would bring in an additional credit, thereby reducing the cost basis accordingly. The challenge is estimating the potential value of the roll. As with calendar spreads, calculating the roll value of a diagonal spread is a lot like playing 'what if' games.

To begin with, let's estimate the roll value for a week before the December expiration and with GLD up just $3 from it's current value of $133.53 to $136.53. I can estimate this roll value using the tools of the thinkorswim by TD Ameritrade platform.

diagonal spread estimating roll value

This is using the trade tab of the thinkorswim platform. In order to perform this estimate, several adjustments are necessary. Several key steps are necessary to start. First, one of the custom columns must be set to 'theo price', which enables some additional adjustment parameters. Second, the spread view type must be set to calendar spread. Since there are December quarterly options, we need to use a 2 month spread since we'll be rolling from December to January (although rolling to December quarterly isn't out of the question).

Once these initial adjustments are made, the date needs to be adjusted forward to the week before expiration and the stock price adjusted up $3. From there we can see that the potential roll value is $2.25. Since this is an estimate, there is no guarantee we'll receive that much on a roll. However, even if we could obtain $1.75 on the roll, that would reduce the cost basis to $5.97. With that cost basis, the potential ROI could be as much as 71%.

Even if this is all that was accomplished with this trade, it would be decent trade.

Position sizing

The problem with this trade in regards to position sizing is the initial cost. The initial cost for just one contract of this diagonal spread  is $772. My typical risk amount per trade is just 2% of the portfolio value. Currently, the portfolio value is $16,316, which means 2% would be $326. That means just one contract of this diagonal spread risks more than twice the amount I'm willing to risk.

In many of my trades such as calendar spreads and diagonal spreads, I often have an exit strategy of closing when the value of the trade loses 1/2 it's initial value. However, that would still mean risking $386. The only way to limit the risk in this trade is to have a stop loss to limit the loss to $326. The risk in doing so is that it might force me out prematurely with a pullback of any size. However, it's the only way to ensure I'm not over extended with this trade.

Exit plan

Planning exits with a diagonal spread are a bit more complicated than more basic trades like vertical spreads. With this kind of trade, there is much more to trade management. This includes rolls.

I want to take a moment to discuss this a little further. In the 4/21/2010 update of the IWM diagonal spread tutorial I talked briefly about rolling the entire trade out to a new diagonal spread. The nice thing about this kind of move is I have the ability establish a new position for a significantly lower cost basis.

There are a couple of possible ways to roll out to this new position. One way would be to simply roll the final position into a new diagonal spread for a significantly lower cost basis. The other is to use the roll to a new position to increase the position size while remaining within risk tolerances. More on this as the trade develops.

In terms of absolute exit/trade management rules, I have just a few. 

  1. I will exit if the value of the spread drops $326, which represents the maximum amount I can risk in this trade.
  2. I will roll the short strike to December quarterly or  January position if the value of the current short strike drops to $.10 or less OR I can roll for at least $1 to December quarterly or $1.75 to the January position
  3. I will exit/roll when approximately 4-5 days of expiration

Portfolio Impact

Since this is a bullish trade, I'd expect the delta impact on this trade to be bullish. In this case, the position adds positive 23 deltas to the portfolio. I'm currently holding 2 diagonal spreads, one of which is a ,more mature position and may be closed or rolled fairly soon.

Update 11/27/2010

This trade has been on for nearly 2 weeks. GLD is down nearly $4 from when the trade was entered yet the position only has an unrealized loss of $2. Why is this?

This is the beauty of spread positions and in particular, this diagonal spread. The short strike's time premium portion of the option price is eroding faster than that of the long strike, which is a month farther out in time in terms of expiraiton.

GLD is now sitting at a support level near the 30 day moving average and just above the 50 day moving average. There is a support level around $130. These will be critical areas to watch as signals to make an early exit.

Being long gold in general can be a nice hedge against inflation and while this trade may not play out as expected, it will definitely play a role in my portfolio going forward. For now, let's see how the next week or two play out. Clearly the economic conditions in Europe have served to strengthen the US dollar somewhat. However I suspect as fear eases the upward climb will resume.

Update 12/9/2010

I went ahead and rolled the short strike today. After a nice run up last week, there was a pretty healthy sell-off this week. Today there was the makings of a bounce (as yet unconfirmed).

I didn't want to wait too long because if this is just a relief bounce then further selling would affect the roll value. Since we are within the last week before expiration, it represents a good time to do the roll. Now, here's the part where we need to make some decisions.

A typical calendar style roll would involve rolling the short December 138 call to a short January 138 call. During my analysis, it looked like the roll value would be about $1.90. This reduces my cost basis to $5.82. Since this is a still a $12 spread, the new potential profit would be $6.18 and an ROI of 80% (based on the initial $7.72 invested).

Let's consider another scenario. What if I were to roll the December short $138 call to a short January $139 call? In this case I'll only receive $1.49 for the roll but the spread widens to $13. Assuming that GLD is above $139 on expiration the potential profit would be $6.77. With this new profit, the ROI would be 87%. This is where the diagonal spread really shines.

The question now is, which is the correct option? Is it just about which offers the highest ROI? Are there other factors to consider? One other point to consider is outlook. If I felt that the outlook is for a continued run up through $139 then the roll up to the short $139 is the better choice. If I felt that the best that could happen is for GLD to reach $138 then rolling to $138 would be the better choice as that would yield the best profit and therefore the best ROI.

The question then is what is my outlook? While there has been some recent selling, I believe the longer term outlook is for GLD to run higher. In fact I am currently bullish on GLD into 2011. I'm hoping to use that bullishness to illustrate one of the nifty management techniques of the diagonal spread.


Update 1/21/2011 (closing update)

Well, after having a computer outage for the last week that left my web content unavailable to edit and upload, I'm back. If you were watching GLD last week (and hopefully you were if you followed this trade), it broke a key support level on Friday. With that, I took a technical signal to close the position.

I had hoped that GLD would have a longer run so I could illustrate some nifty long term trade management strategies with diagonal spreads. Alas, it won't be with this trade. Today, I'm looking at GLD and I'm really glad I exited when I did. Let's see how the trade turned out.

I originally entered this trade with one contract for a debit of $7.72. This was a one month Jan/Dec diagonal spread. I rolled the short strike to a vertical spread (adding $1 to the width) for a credit of $1.40. Finally, I closed the spread for a credit of $6.45. That means I ended up with only $13. That's not too great but considering the turn in GLD, I guess I'm happy to show any profit at all!

What could I have done differently to improve the profitability of this trade? First of all, when I considered the roll, I talked about the tradeoff of rolling directly across to the same strike vs rolling up and making the spread wider. To do so, I gave up some of the credit on the roll. In fact if I'd simply rolled across I could have kept an additional $.50. Another place where I could have improved my profitability is closing a day earlier when it was clear a lower high was forming. In fact going back to the beginning of January, there was a failure (for the third time) to make a new all time high.

Obviously hindsight is 20/20, but this is an example of how using technical analysis can help improve the timing of our entries and exits.

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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