Options: The Diagonal Call Spread

This limited-risk, limited-reward play is great for volatile stocks

   

Although the title of this article sounds like some kind of medieval torture, it’s actually an options strategy — one designed to profit from a situation where you expect neutral activity during the first month, then bearish developments in the second month.

This might be best used, for example, in the month before a momentum stock reports earnings and the month when it does, and you expect a bad result.

Strategy

Here’s the play:

  • First, sell an out-of-the-money call, strike price X, in the first, or “front” month.
  • Second, buy a further out-of-the-money call, strike price Y, in the second, or “back” month.
  • At expiration of the front-month call, sell another call with strike X and the same expiration as the back-month call.

Generally, the stock’s price will be below strike X. In the ideal circumstance, you will generate a net credit by selling the calls.

Because we’re dealing with options, we would like to see some initial volatility, because the plan is to sell two options, and you want to generate as much premium as possible. However, it’s best if the stock price remains stable.

As far as the trade possibilities go …

  • Maximum profit: It’s limited, but that’s fine because this is an income-driven strategy. That maximum is thus net credit received for selling both calls with strike X, minus the premium paid for the call with strike Y.
  • Maximum loss: Not much. It’s limited to the difference between strike X and strike Y, minus the net credit received (or plus the net debit paid).
  • Breakeven: Unlike most of the other trades I’ve written about, you can’t really peg a breakeven, because it depends on how much you sell that second call for, and you won’t know that until front-month expiration. The ideal scenario is thus, during the front month, you want the stock price to stay at or around strike X until expiration. For the back month, you want the stock price to be below strike X when the back-month option expires.

Trade Example

I’m going to choose Priceline (NASDAQ:PCLN) because there’s a lot of volatility, which also means good premiums.

The stock closed Thursday at about $709. The May 710 Calls can be sold for $29. The June 715 Calls can be bought for $33. Now, we can’t anticipate where Priceline will be at May expiration, but let’s assume it’s at $709 for simplicity’s sake. The June 710 Call could be anything, but let’s assume it’s less than what we’d get for the May strike to be conservative — say, $23.

If Priceline hits June expiration at $709, you’ll have a net credit of $2,900 + $2,300 – $3,300 = $1,900. None of your calls get exercised. Very nice!

If Priceline hits June expiration at $710, the result is the same. No calls get exercised. However, between $710 and $715, you will have your stock “called away,” having sold those $710 calls. So if you don’t own the stock, you’ll have to purchase it, reducing your net credit, but not eliminating it.

If the stock is over $715 come June, you’ll be covered, because you own the June $715 Call, allowing you to purchase Priceline at $715 at any time.

As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at pdlcapital66@gmail.com and follow his tweets @ichabodscranium.


Article printed from InvestorPlace Media, http://investorplace.com/2013/04/options-the-diagonal-call-spread/.

©2014 InvestorPlace Media, LLC

Comments are currently unavailable. Please check back soon.