Options: The Diagonal Call Spread

by Lawrence Meyers | April 18, 2013 10:30 am

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:

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 …

Trade Example

I’m going to choose Priceline (NASDAQ:PCLN[1]) 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[2] did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc.[3], which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books[4] and blogs about public policy, journalistic integrity, popular culture, and world affairs[5]. Contact him at pdlcapital66@gmail.com[6] and follow his tweets @ichabodscranium.

Endnotes:
  1. PCLN: http://studio-5.financialcontent.com/investplace/quote?Symbol=PCLN
  2. Lawrence Meyers: mailto:pdlcapital66@gmail.com
  3. PDL Capital, Inc.: http://www.pdlcapital.com/
  4. written two books: http://www.investorplace.com/author/lawrence-meyers/
  5. blogs about public policy, journalistic integrity, popular culture, and world affairs: http://www.breitbart.com
  6. pdlcapital66@gmail.com: mailto:pdlcapital66@gmail.com

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