Diagonals April 07

holzie said: "Ok, since our RUT trade is gonna be really boring this month because we are not gonna touch it to avoid getting whipsawed I will start a new thread about my other positions I started building during the "crash". This is called diagonal spread, not to confuse with double diagonal spreads, which I do NOT do. What is a diagonal. Diagonal is a spread in which you buy long XYZ at lower strike and farther out and sell short XYZ in the higher strike in closer month. For example: +1 HOG AUG07 $60 @ 5.30 -1 HOG APR07 $65 @ 0.60 ------------------------------ Total debit 5.30 - 0.60 = 4.70 This position will give you the right to control 100 shares of HOG until August, and you are basically using the long option to simulate a covered call, except that it didn't cost you $61.45 * 100 = $6145 for the stock but only $530. So, your return on this "covered call" is 60/530 = 11.32% vs. 60/6145 = 0.98%. Ok, now I am gonna show you guys how I use it."

drdan said: "This is one of my favorite ways to trade if you have a really small account and you are just starting out trading options. Maybe I'll post one as well, Holzie, in a different thread. Got to find one first I guess. :laugh:"

bklambco said: "Great! keep it going... :th_dblthumb2:"

holzie said: "Alright, you know the basics of diagonals and now I am gonna show how I use it my way. I love options but deep down, I am a stock guy but I hate the cost associated with buying stock of companies I consider great. So I don't want to spend the money but I want to control the stock. The disadvantage here is that on a dividend stock like BAC, I don't get the dividend AND I still run into time decay of my investment. But I get around that. First of all, I don't like when I have wild swings in my options I am holding because I am not there to watch it all day. So I want something that moves but not as fast. So for the long option I like to use LEAP calls, January 2008 and January 2009 to give me as much time to control the stock as my budget for 1 company allows (I have several of them at one time). Once I have the LEAP, I sell 1 current month call in the strike that gives me a) decent premium in case it gets exercised or b) lower probability of reaching the short strike so I get to keep the LEAP and the control of the stock and sell the next month for premium. To understand this better I am gonna post 3 of my current positions and costs: +1 BAC Jan08 $50 @ 3.60 -1 BAC April07 $52.50 @ 0.30 ---------------------------------- You can look at it as either I am getting a $30 dividend on "owning" 100 shares of BAC for $360 vs. $5186 OR you can look at it as I am lowering my cost basis of the LEAP by 0.30, so right now I own the LEAP for 3.60 - 0.30 = 3.30. The value of the LEAP right now is $4.50. This is what can happen on April 20 expiration: 1) BAC is between $49.50 and $52.50, I keep the $30 premium and the LEAP and I can sell the May $52.50 or $55 call depending how close to each strike I am. Again, I want to get some meaningful premium BUT I will not almost voluntarily give up the LEAP by selling it too close to the next strike. 2) BAC is more than $52.50, let's say $53, in that case my short call ($52.50) is assigned and my broker will exercise my $50 leap, but the net of the position will be around $130 after it's all settled (including the premium received), so the profit for the month would be 130/360 = 36.11%. Though it's good return, I really would like this not to happen, because I would have to sit and wait until I get some meaningful pullback on the stock so I could buy another LEAP for a good price. I wouldn't just re-acquire the LEAP I just lost the next day, just like I wouldn't buy the stock on the high of the month/quarter. 3) Stock is less than $50, let's say $48. I this case I would keep the 0.30 premium and the LEAP would be worth approximately 3.00. My cost basis now is 3.20 so I would be down $20 on paper. I could do 2 things. If the stock goes even lower, I would buy another leap around 2.50, but I don't have to. Or I would wait until the stock went a little bit up, maybe $49 to sell the May $52.50 for at least 0.20, getting me some income for May -- OR both, which is why you always leave some money as a reserve. Because of scenario 3, you can see that as in anything, you can still endup down on the paper for the month, which in options is trouble because you don't have time to wait for the Market to come to its senses. Because of this possibility, this is the reason why I don't mind paying up a little more for a 08 or 09 leap. I have 9 months or 21 months to overcome a short-term dip. The best outcome of this is aiming to trade upwards with the stock while not loosing that leap, so you sell the higher and higher strikes but keep the original strike leap. What I mean is, let's say it's October07 and the BAC stock is at $55.50. Your cost of the leap has been reduced 1.00 and you are still selling the $57.50 November07 call for 0.30. You leap's market value is around 6.00-7.00 (because of time decay). AS good as it sounds, this scenario is so unlikely in my experience that you will find yourself in scenario 2 in 2-3 months anyways, no matter how you play it, which is ok. I have to say it again, this should not be the only option strategy you have. You option portfolio should consist of an array of strategies every month to diversify risk. The more strategies you know how to use the better you can trade in any market. Great example was last month and my loss of my RUT iron condor. If this has been the only trade I had on that month, I would be in bad shape. Instead, my other strategies helped nicely offset my loss. Right now, I have 50% cash. Of the cash in use, I have a RUT call spread, 3 diagonals (BAC, INTC, CSCO), and 1 covered call (IMH), 1 naked put (IMH to acquire the stock at lower price). If you have any questions, let me know. Holz."

drdan said: "[QUOTE=holzie]I have to say it again, this should not be the only option strategy you have. You option portfolio should consist of an array of strategies every month to diversify risk. The more strategies you know how to use the better you can trade in any market. Great example was last month and my loss of my RUT iron condor. If this has been the only trade I had on that month, I would be in bad shape. Instead, my other strategies helped nicely offset my loss. Right now, I have 50% cash. Of the cash in use, I have a RUT call spread, 3 diagonals (BAC, INTC, CSCO), and 1 covered call (IMH), 1 naked put (IMH to acquire the stock at lower price). If you have any questions, let me know. Holz.[/QUOTE] Excellent advice! It took me a cople of years to learn this one. I was just jumping from strategy to strategy thinking that each one was the answer to my prayers. Now I know that each one when used appropriately is the answer to my prayers."

holzie said: "[QUOTE=drdan]This is one of my favorite ways to trade if you have a really small account and you are just starting out trading options. Maybe I'll post one as well, Holzie, in a different thread. Got to find one first I guess. :laugh:[/QUOTE] Yep, I love it. I hate double diagonals because I always get the "sack" in the middle and it is really so close to iron condors that I see little point in using it instead of ICs. But, when it comes to just diagonals, I absolutely love it. AS far as risk goes, it is just a notch riskier than a covered call, but I limit this risk by using a leap with a 0.70 or better delta. If you really want to be "anal" about it, my potential dollar losses are lower than if I owned the stock (my percent losses are higher of course). For example, if BAC looses a $1 and I own the stock, I am down $5000 - $4900 = $100. But my leap with 0.70 delta will loose 0.70 * 100 = $70. As I said, the percentage loss is different. On the stock 100/5000 = 2%. On my leap it's 70/360 = 19%, but you still have to think about it in terms of you having 5000-360 = $4640 more to invest by not buying stock but buying the leap. Like you said, it's a great way to play options."

holzie said: "[QUOTE=drdan]Excellent advice! It took me a cople of years to learn this one. I was just jumping from strategy to strategy thinking that each one was the answer to my prayers. Now I know that each one when used appropriately is the answer to my prayers.[/QUOTE] Lol, it took me loosing my entire capital the first year to learn this one as well:) I think if these guys take anything from our posts, if they only learn this one from us, they will be in great shape."

rrvball said: "Thanks Holzie and DrDan, I have been trading options sparsely for a few years now and mostly ITM longer term puts and calls with some covered calls and covered puts thrown in here and there. I've been looking for that one strategy as DrDan said and was thinking that I could just use one strategy. Thanks for saving me!!! Now for a question about diagonal spreads, I've been looking at these lately in place of covered calls. One thing I don't understand and I think it's reflected in your case 2) is what happens if your short call gets assigned. You said: [QUOTE]2) BAC is more than $52.50, let's say $53, in that case my short call ($52.50) is assigned and my broker will exercise my $50 leap, but the net of the position will be around $130 after it's all settled (including the premium received), so the profit for the month would be 130/360 = 36.11%. Though it's good return, I really would like this not to happen, because I would have to sit and wait until I get some meaningful pullback on the stock so I could buy another LEAP for a good price. I wouldn't just re-acquire the LEAP I just lost the next day, just like I wouldn't buy the stock on the high of the month/quarter.[/QUOTE] You paid 3.60 for the LEAP and received 0.30 for the short call. So, you're at a debit of $3.30 or $330. At exercise, your short call was assigned, meaning you had to sell the stock at 52.50 and your broker exercised your LEAP to cover the assignment, meaning you bought the stock at 50. So, wouldn't your net actually be (52.50 - 50) - 3.30 = -0.80/share = -$80??? How did you come up with a profit of $130? I'm guessing your profit comes from the value of your LEAP at APR expiration being greater than 2.50 (~4.60 = 3.30 + 1.30 from your profit result). Since, I've never done one of these and gotten assigned, what keeps the broker from just exercising your LEAP to cover the assignment and giving you only the difference in the strikes, 2.50 in this case, and keeping the rest for himself or the brokerage?"

drdan said: "[QUOTE=rrvball]You paid 3.60 for the LEAP and received 0.30 for the short call. So, you're at a debit of $3.30 or $330. At exercise, your short call was assigned, meaning you had to sell the stock at 52.50 and your broker exercised your LEAP to cover the assignment, meaning you bought the stock at 50. So, wouldn't your net actually be (52.50 - 50) - 3.30 = -0.80/share = -$80??? How did you come up with a profit of $130? I'm guessing your profit comes from the value of your LEAP at APR expiration being greater than 2.50 (~4.60 = 3.30 + 1.30 from your profit result). Since, I've never done one of these and gotten assigned, what keeps the broker from just exercising your LEAP to cover the assignment and giving you only the difference in the strikes, 2.50 in this case, and keeping the rest for himself or the brokerage?[/QUOTE] Well the one piece of information that Holzie left out was what was the stock at when he placed the trade, then you could have figured out the intrinsic and the time value of the $50 call. Here's how he figured out profit - sold 52.50 bought at $50 = $2.50 profit add to that the premium of the sold $52.50 of .30 and then subtract the time value (premium) of the $50 call and commissions. I am going to assume that this was $1.50 for Holzie, which nets you $1.30 or $130."

bklambco said: "In option 2, when your broker exercises your 50.00 leap do you have to have the $5000.00 cash in your account? Never done a diagonal before so just wondering how that assignment works. In a covered call you just give up your stock which would be worth the what ever since you already own the stock. So I am guessing in this diagonal your broker has to go out buy the stock then give it up? So you need to have the cash sitting around in case it happens."

Rbreb13 said: "[QUOTE]Dumb question. [/QUOTE]Not that dumb. I wanna know too."

drdan said: "No you already sold the stock for 52.50, so you are just covering the sold position."

holzie said: "[QUOTE=drdan]Well the one piece of information that Holzie left out was what was the stock at when he placed the trade, then you could have figured out the intrinsic and the time value of the $50 call. Here's how he figured out profit - sold 52.50 bought at $50 = $2.50 profit add to that the premium of the sold $52.50 of .30 and then subtract the time value (premium) of the $50 call and commissions. I am going to assume that this was $1.50 for Holzie, which nets you $1.30 or $130.[/QUOTE] Yes, sorry about that. DrDan is exactly right in calculating profits that way. In my case, and I didn't mention this in the scenario 2 for the sake of avoiding even greater confusion, I bought the $50 leap when the stock was under 50, which means that I paid for time control (extrinsic value only). This sort of complicates things in the way how I will ACTUALLY handle scenario 2 based on my CURRENT costs -- remember, scenario 2 will work best only after I work off the time premium by selling enough calls against it or by being in a much higher strike few month from now. So in reality, if on April 20th I see BAC trading at $53, my leap should be worth around 5.50 and the short call will have an intrinsic and final value of 0.50 (I sold it for 0.30). I will not wait one more day to exercise and get assigned because of the reasons DrDan stated above -- I would only based a profit of 52.50-50 = $250 - $330 (cost of leap) - 2*$15 (assignment and exercise), so I would be negative $110. Instead, on that Friday I would buy back my short call for 0.50 ($20 loss) and either kept my leap to sell the $55 strike for next month or sell the leap on the same day as well if I saw a better opportunity elsewhere. In this case, I would sell the leap for $550 and my total profit would be 550 - 360 - 20 = $170. I said $130 in my example because I was estimating the value of the leap, but today I checked the pricing model and the value wouldn't be 5.00 but 5.50. It's not as complicated as it sounds, believe me. It's just not as clear cut decision until you get there but it's all about the circumstances and bottom line -- you have to be flexible. My decision will also be influenced by the premiums in the $55 strike so I may take to 0.20 loss from the short call and control the stock another month with a prospect of higher reward. Holz."

drdan said: "That makes more sense, because I could not figure out how in the world you bought a LEAP (that far out) with only $1.50 time value. LOL I was going to have to retract my statement about finding option bargains!"

bklambco said: "Is this correct. bto 50.00 jan08 @ 3.60 = $360.00 debit sto 52.05 apr07 @ .30 = $ 30.00 credit cost to open = $330.00 Condition 2 happens sto 52.50 is exercised 52.50 - 50.00 = 2.50 * 100 = $250.00 - 30.00cr = 230.00 loss $330 paid to open - 230 excercised loss ------- 100.00 loss"

drdan said: "[QUOTE=bklambco]Is this correct. bto 50.00 jan08 @ 3.60 = $360.00 debit sto 52.05 apr07 @ .30 = $ 30.00 credit cost to open = $330.00 Condition 2 happens sto 52.50 is exercised 52.50 - 50.00 = 2.50 * 100 = $250.00 - 30.00cr = 230.00 loss $330 paid to open - 230 excercised loss ------- 100.00 loss[/QUOTE] No, if you are assigned and exercised your gross profit is $250 plus the premium of the sold option or $280. remember it is just like shorting a stock. You short at 52.50 and then you buy to cover at $50. You make money. You do not lose money in this situation. Now you factor in the price you paid to put on that position. Since Holzie bought the $50 option with only time value meaning he bought it out of the money you subtract the entire amount he paid which is $3.60 which is an $80 loss add to that the commissions which he stated as $30 which equals a loss of $110."

drdan said: "[QUOTE=bklambco]Is this correct. bto 50.00 jan08 @ 3.60 = $360.00 debit sto 52.05 apr07 @ .30 = $ 30.00 credit cost to open = $330.00 Condition 2 happens sto 52.50 is exercised 52.50 - 50.00 = 2.50 * 100 = $250.00 - 30.00cr = 230.00 loss $330 paid to open - 230 excercised loss ------- 100.00 loss[/QUOTE] Lets try it your way.... bto 50.00 jan08 @ 3.60 = $360.00 debit sto 52.05 apr07 @ .30 = $ 30.00 credit cost to open = $330.00 Condition 2 happens sto 52.50 is exercised 52.50 - 50.00 = 2.50 * 100 = $250.00 gain $250 gain - $330 open _____ $80 loss plus commissions"

holzie said: "Exactly, so now you see why in one single scenario, you can either eat a $110 loss or walk away with a $170 profit on a $360 investment. The difference is only in the usage of the options in your position, which is why I always stress the importance to know what you are doing before you put real money on the line. But this is a great strategy but doesn't work for every stock. Take VZ for example, great company but the diagonals would stink because the $40 strike, which is only $2 away doesn't yield but 0.05 in premium. If the stock or market doesn't go anywhere, the time decay will eventually eat you because you were not able to offset it by selling the higher strike calls. There are 2 companies I am looking at really hard for diagonals: HOG and AAPL. The first one, HOG is ripe for a trade now and AAPL needs a "hit" to come down to at least $85 to buy the $80 strike leap. HOG is just too damn cheap for what a company it is. So these are just ideas..food for thought :)"

rrvball said: "Ok, so I did my math correctly and if you let the option get assigned and exercised, you will lose $80 plus commissions. So, the key here is that if the short call is ITM, buy it back and either sell your LEAP (for a profit most likely unless some weird volatility occurred) or sell another short call for the next month out. You just confused me by saying that your short call would be assigned and your broker would exercise your LEAP. But, in reality, you wouldn't let that happen. I got it now!!! Thanks for the clarification."

bklambco said: "Bingo bingo...got it works just like a covered call....:roll: I really like this strategy now, I have been helping a friend who has lots of money with covered calls and covered puts, He buys the stocks, My account is not big enough to do what he does, so this is perfect. Next question is how much does the broker sock you for on margin is it the same for the Iron condors on SPX as an example? I'm with TOS. [QUOTE=drdan]Lets try it your way.... bto 50.00 jan08 @ 3.60 = $360.00 debit sto 52.05 apr07 @ .30 = $ 30.00 credit cost to open = $330.00 Condition 2 happens sto 52.50 is exercised 52.50 - 50.00 = 2.50 * 100 = $250.00 gain $250 gain - $330 open _____ $80 loss plus commissions[/QUOTE]"

holzie said: "[QUOTE=bklambco]Bingo bingo...got it works just like a covered call....:roll: I really like this strategy now, I have been helping a friend who has lots of money with covered calls and covered puts, He buys the stocks, My account is not big enough to do what he does, so this is perfect. Next question is how much does the broker sock you for on margin is it the same for the Iron condors on SPX as an example? I'm with TOS.[/QUOTE] Don't confuse buying stock on margin and having "margin" held because of a limited risk position like the IC. On a 10 points spread IC on the SPX, the margin requirement is $1000 - premium received, HOWEVER you are using your own money, the broker just set your money "aside" in case you loose, thus no margin charge. Same goes for these diagonals. There is absolutely no margin requirement at any given time, because you are using your own money (debit). You would be charged margin if you bought let's say 100 shares of BAC on margin (50 shares cash and 50 borrow from broker). I really don't like margin in this case, because your account trading funds could be all over the place each day and could cause you to be locked in a difficult position just because you don't have the available cash to get out, roll, etc. Back to your question though. Yes, this is very similar to a covered call just slightly more complicated because you are dealing with 2 different options instead of worrying about 1 short option and stock. But the yields are great for the amount of risk. Just make sure you do this with companies that make sense, which means no biotech, no oil, nothing wacky. You want to use options in this strategy for leverage only, not for speculation."

rrvball said: "[QUOTE=bklambco]Next question is how much does the broker sock you for on margin is it the same for the Iron condors on SPX as an example? I'm with TOS.[/QUOTE] Correct me if I'm wrong, but you wouldn't have any margin required at all for this trade. The long LEAP acts like the stock in a covered call. You purchase the LEAP instead of the stock and your account would be debited the $330. No margin is required since the LEAP covers the short call. That's the beauty of this strategy. You get the benefits of a covered call but you put up much less money up front."

drdan said: "[QUOTE=holzie]Back to your question though. Yes, this is very similar to a covered call just slightly more complicated because you are dealing with 2 different options instead of worrying about 1 short option and stock. But the yields are great for the amount of risk. Just make sure you do this with companies that make sense, which means no biotech, no oil, nothing wacky. You want to use options in this strategy for leverage only, not for speculation.[/QUOTE] My rules for a beginner option trader using this strategy.. 1. good fundamental stock in a slow upward trend 2. stock price between $20 and $50 3. buy an in the money long term (LEAP) call 4. sell an out of the money call one strike above the current price in the current month or one month out. this is not the most profitable way to use this strategy but it is the safest to learn from, adjust from there when your knowledge and experience increase, then you can do something crazy like buy an out of the money call and sell calls against that!!! :roll:"

holzie said: "Another possible Q&A I will answer in advance. Why are we trying to buy a deep in the money or in the money leap, when we could as well buy an option 3-6 months out for less? The answer to this is safety. You know that options 30 days or less are highly volatile so it is not unusual to have a swing of 100% in either direction. It's less volatile further out, but when you have a leap, and especially deeper in the money leap, the worst swings are +/- 10%, which provides you with some stability in your position. You will still pay much less for the leap than for a stock, thus driving your profit yields higher."

bklambco said: "Great on margin question. I see because we are buying the leap there is no margin, simular to covered call. Where when we are doing credit spreads on RUT and SPX we get hit with a lot of cash required up front, and if your strike gets hit your head gets blown off too. I know the beauty of the credit spread is the probability is high to make money but the RR risk/reward is very bad. So I have been thinking I need to add something that does not cost me an arm and a leg getting into and out of a trade. I will have to try out a practice diagonal to get the feel. I have seen I guy on EliteTrader.com forum that uses the diagonal very heavy on the spx indexes he has been at it for years. I think he makes out ok, what do you think of using it on an indexes, just a thought?"

bklambco said: "This makes alot of sense. Its in the 30 day window where the credit spreaders earn their bread and butter do to the rapid deteriation wasting aset. Someone new to options will actually buy these options in the 30 day window and wonder what hit them. So how far out is reasonable for the diag because eventually it will begin to deteriate? [QUOTE=holzie]Another possible Q&A I will answer in advance. Why are we trying to buy a deep in the money or in the money leap, when we could as well buy an option 3-6 months out for less? The answer to this is safety. You know that options 30 days or less are highly volatile so it is not unusual to have a swing of 100% in either direction. It's less volatile further out, but when you have a leap, and especially deeper in the money leap, the worst swings are +/- 10%, which provides you with some stability in your position. You will still pay much less for the leap than for a stock, thus driving your profit yields higher.[/QUOTE]"

holzie said: "[QUOTE=bklambco]This makes alot of sense. Its in the 30 day window where the credit spreaders earn their bread and butter do to the rapid deteriation wasting aset. Someone new to options will actually buy these options in the 30 day window and wonder what hit them. So how far out is reasonable for the diag because eventually it will begin to deteriate?[/QUOTE] Yes, exactly. This is why you want to be on the selling end for short term options, especially 30 days or less. As far as how far out...rule of thumb, minimum 6-8 months and the key here would be going quite deep in the money -- 2 strikes is decent. This way you get slower time decay and you pay much less for the premium or extrinsic value. But these options are still traded pretty actively so you will see some swings in price every day. I still like the leaps though, because it means I have a lot of time left to control the stock. I pay more for them obviously but I don't have to be as focused on the immediate future as I would with a 6 month option."