Secret 100 THE DIAGONAL SPREAD

One of my favorite trades is the diagonal spread. A diagonal

spread is a time or calendar spread. The diagonal spread that I

love to design is a special credit time spread. Here you write the

near term option that is out-of-the-money and buy an option further

out in strike and time in a longer term option.

However, I only do trades where there is a credit. This is a

riskier trade. You are again at risk for the distance between the

strike prices less the credit, but when the option you have written

expires, you still own the longer term option. Again, use a

stop-loss to prevent moving into-the-money of the option you

have written.

Let’s take a theoretical example. In June, if XYZ stock price

is 30, sell the July 35 call and buy the Oct 40 call. If you get a

credit for doing this, you probably have a good play. Specifically,

if the July 35 call is 1.5, and the Oct 40 call is 1, you get a credit

of .5. Set a stop-loss at about 36. If XYZ stock does not hit 36 before

expiration or exceed 35 at expiration, you pocket the .5 point

credit, yet you still own the Oct 40 call as a kicker.

Therefore, you can win in two ways, first keeping the credit

and second owning the longer term option. Use a simulator to

make sure you have a low probability of hitting the stop-loss.

Finding such a trade is not as easy as it looks, but those

gems are there if you take the time to search for them. Try to stay

with 5 point spreads if possible and the further out timewise, the

better for the option you are buying.

Let’s take an actual example, Anheuser- Busch Companies

(BUD) on September 26, 2002:

Buy BUD Jan 60 call at .6

Sell BUD Nov 55 call at .9

Stock price = 52.2 Spread Credit of .30

Stop at 56.1. Value of Jan 60 call is .20 at November

expiration

Total profit at November expiration = .30 + .20 = .50

With this example, if BUD does not hit 56.1 or exceed 55 at

November expiration, you would capture the .30 credit. However,

you still own the BUD Jan 60 call, which was priced at .2. Consequently,

if you were to cash in at that time, you have a total gain

of .5 ($50).

During 2002 I recommended 18 diagonal spreads. Fifteen

were profitable, or 83%, and the three that were losses were

small losses.

Here are the guidelines that were followed to create these

diagonal spreads:

1. Sell or write an option where the strike price is about 3

to 5 points or further out-of-the-money.

2. Buy an option that expires 1 month or more after the option

you have sold that has a strike price that is 2 1/2 to 5

points from the strike price that you sold.

3. Try to get a credit or, at the very least, a very small debit

for the spread price.

4. Set a stop-loss that is slightly in-the-money of the option

that you have sold (i.e. a 55 call would have a stop at 56).

5. Try to select a spread where the option you are writing

has less than 2 months before expiration.

6. Exit the spread when the stop is hit or at the expiration of

the option you wrote or if that option loses most of its

value.

7. With this trade you get a free option, the option you

bought initially, so you could hang on to it, if you wish,

after the option you have sold expires.

Here are some additional diagonal spreads, recommended in

September of 2002:

1. Date entered: September 19, 2002.

Buy Bank of America (BAC) Nov 75 call BAC is at 63.35

Sell BAC Oct 70 call Stop at 71

Spread credit of .25

Value of Nov 75 call at Oct expiration is 1

Total profit = 1.25 (1 + .25)

Position did not hit stop.

2. Date entered September 12, 2002

Buy Duke Energy (DUK) Jan 27.5 call Duke Energy is

at 22.54

Sell DUK Oct 25. call Stop at 26

Spread credit of .05

Value of Jan 27.5 call at Oct expiration is .5

Total profit = .5 + .05 = .55

Position did not hit stop.

In both cases the stock didn’t hit the stop, so a profit was

guaranteed because we had a credit or money in our pocket when

we entered the trade. However, even if the stock hit its stop, you

may still have a profit as the option you have purchased expands

in value.

One advantage of these trades is that even if the stop-loss is

hit, you may still have a profit in the position, especially if it is

close to expiration of the option you have written.

Close out the whole spread at the expiration of the option

you have written, unless that option loses most of its value, but

use some common sense here. If the longer term option you hold

has little value, hold on to it. Surprise volatility may give you a

surprise payoff.

One of my favorite trades is the diagonal spread. A diagonal

spread is a time or calendar spread. The diagonal spread that I

love to design is a special credit time spread. Here you write the

near term option that is out-of-the-money and buy an option further

out in strike and time in a longer term option.

However, I only do trades where there is a credit. This is a

riskier trade. You are again at risk for the distance between the

strike prices less the credit, but when the option you have written

expires, you still own the longer term option. Again, use a

stop-loss to prevent moving into-the-money of the option you

have written.

Let’s take a theoretical example. In June, if XYZ stock price

is 30, sell the July 35 call and buy the Oct 40 call. If you get a

credit for doing this, you probably have a good play. Specifically,

if the July 35 call is 1.5, and the Oct 40 call is 1, you get a credit

of .5. Set a stop-loss at about 36. If XYZ stock does not hit 36 before

expiration or exceed 35 at expiration, you pocket the .5 point

credit, yet you still own the Oct 40 call as a kicker.

Therefore, you can win in two ways, first keeping the credit

and second owning the longer term option. Use a simulator to

make sure you have a low probability of hitting the stop-loss.

Finding such a trade is not as easy as it looks, but those

gems are there if you take the time to search for them. Try to stay

with 5 point spreads if possible and the further out timewise, the

better for the option you are buying.

Let’s take an actual example, Anheuser- Busch Companies

(BUD) on September 26, 2002:

Buy BUD Jan 60 call at .6

Sell BUD Nov 55 call at .9

Stock price = 52.2 Spread Credit of .30

Stop at 56.1. Value of Jan 60 call is .20 at November

expiration

Total profit at November expiration = .30 + .20 = .50

With this example, if BUD does not hit 56.1 or exceed 55 at

November expiration, you would capture the .30 credit. However,

you still own the BUD Jan 60 call, which was priced at .2. Consequently,

if you were to cash in at that time, you have a total gain

of .5 ($50).

During 2002 I recommended 18 diagonal spreads. Fifteen

were profitable, or 83%, and the three that were losses were

small losses.

Here are the guidelines that were followed to create these

diagonal spreads:

1. Sell or write an option where the strike price is about 3

to 5 points or further out-of-the-money.

2. Buy an option that expires 1 month or more after the option

you have sold that has a strike price that is 2 1/2 to 5

points from the strike price that you sold.

3. Try to get a credit or, at the very least, a very small debit

for the spread price.

4. Set a stop-loss that is slightly in-the-money of the option

that you have sold (i.e. a 55 call would have a stop at 56).

5. Try to select a spread where the option you are writing

has less than 2 months before expiration.

6. Exit the spread when the stop is hit or at the expiration of

the option you wrote or if that option loses most of its

value.

7. With this trade you get a free option, the option you

bought initially, so you could hang on to it, if you wish,

after the option you have sold expires.

Here are some additional diagonal spreads, recommended in

September of 2002:

1. Date entered: September 19, 2002.

Buy Bank of America (BAC) Nov 75 call BAC is at 63.35

Sell BAC Oct 70 call Stop at 71

Spread credit of .25

Value of Nov 75 call at Oct expiration is 1

Total profit = 1.25 (1 + .25)

Position did not hit stop.

2. Date entered September 12, 2002

Buy Duke Energy (DUK) Jan 27.5 call Duke Energy is

at 22.54

Sell DUK Oct 25. call Stop at 26

Spread credit of .05

Value of Jan 27.5 call at Oct expiration is .5

Total profit = .5 + .05 = .55

Position did not hit stop.

In both cases the stock didn’t hit the stop, so a profit was

guaranteed because we had a credit or money in our pocket when

we entered the trade. However, even if the stock hit its stop, you

may still have a profit as the option you have purchased expands

in value.

One advantage of these trades is that even if the stop-loss is

hit, you may still have a profit in the position, especially if it is

close to expiration of the option you have written.

Close out the whole spread at the expiration of the option

you have written, unless that option loses most of its value, but

use some common sense here. If the longer term option you hold

has little value, hold on to it. Surprise volatility may give you a

surprise payoff.