Method 2 : How To Setup A Bullish Long Term Diagonal Spread
This strategy is known also a poor man’s covered call and definitely deserves a place within your trading arsenal. The long term diagonal spread strategy simply replaces the long stock positions in your portfolio with deep in the money call options. Furthermore we chose call options usually that don’t expire for a number of years and their delta (the change in an option’s value for a change in the price of the underlying product). is usually above 0.8.
This strategy is a no-brainer for the investor/trader who has a small account but still wants heavy diversification. Furthermore if we return to Gilead for example from the last post, here is how a potential long term income trade could be set up. With the move Gilead had after its second quarter earnings announcement, adopting this strategy is smart play as it puts far less capital at risk compared to owning stock outright. Here is how would set it up.
1. We look for a liquid long term in the money call option.
If we pull up an options chain again and go for the longest expiry we can find (January ‘2019 or 534 days out), we can see that we can buy the 80% delta in the money call option (60 call) for around $17.60. What does this mean ? It means we can control 100 shares of Gilead through a long term LEAP call option for $1,760. Buying 100 shares on the market this very minute would cost over $7,500 so this is already a saving of almost $6,000 already. This option’s value will move roughly 80% of what the stock will move.
This long call essentially now plays the same role as long stock does in a traditional covered call strategy. That’s the long component sorted out. Now its time to sell call(s) against this long position
2. Sell 30 to 45 day calls against this long position
Now all we have to do is adopt the same trading strategy as we did in the last example. We sell out of the money calls ( 30 to 45 days away) and buy them back we when have at least a 30 to 50% gain on the calls. As the option chain illustrates below, the most likely candidate at present would be the September $77.5 call which currently is worth around $1.13. As we can see the delta of this particular call is 37%. However if this call were to get in the money, its delta would change pretty quickly which is why this trade has to be set up properly from day 1. Here is how we do it.
3. How To set up a long term diagonal or “Poor Man’s Covered Call” trade from scratch
The one thing you have to be careful with in the long term diagonal spread strategy is that there is sufficient long deltas in your call because if the price of the underlying goes up (which means the short call goes in the money), we still want to make sure that we have a profitable trade on our hands. Here is how we do it. The formula I use is the following
Price of the LEAP long call < Width of the Strikes + Price of the short call
(Gilead Example) $17.60 < (77.5 – 60 = 17.5) + (1.13)
$17.60 < $18.63 – We Are Good to Go
Doing this work beforehand ensures that if the price of Gilead spikes up, the long call will rise in value quicker than the short call. Management of the trade is the exact same as the traditional covered call strategy when the short call remains out of the money. We just take profits when they present themselves (only on the short-dated short call) and the wait for Gilead to rally once more so we can sell more out of the money calls (30 to 45 days out) against our long fixed LEAP option. Trade management though is different if the price of the stock gaps through our short call. Here is how we do it.
4. Trade Management of a Diagonal Spread when the short call is deep in the money.
Firstly you need to watch the specific deltas of your trade. For example, if the short call gets deeper and deeper in the money (stock gaps through your short strike aggressively), the price of the short call will eventually rise in value faster that the long call. This is always my cue to exit the trade which will always be a winner. Let me explain by showing you a screenshot of a similar trade I have on at the moment in (NYSE:GDX) which is a diagonal spread
As the screenshot shows, GDX is presently trading at the $22.85 mark. I am short the $23.5 call in September and long the December $21 call. One does not have to be worried about closing this diagonal in full until the short call goes in the money (above $23.50). When it does, I really get clued into the deltas on both the long and short components of the trade. As you can see from the screenshot, the “Delta Dollars” of the long call is still much larger (1,675) than the (873) we have on the short call. If GDX keeps rallying the difference will get smaller. Ultimately when I see only a marginal difference in delta dollars between both sides of the trade, I would close the whole trade out for a winner and move on to the next trade.
The second area to watch is the dividend. Be mindful of dividend dates and take the trade off (in full before 4 to 7 days before the ex-dividend date) if the call is well in the money. If you don’t, you could wake up one morning and find that your short call has now become short stock which means you will be on the hook for payment of the dividend. Its just not worth the risk. Remember, the whole trade should be a winner if the short call is in the money. Take your profits and move on. Don’t try to get too greedy here by hoping your short call finishes out of the money by the expiration date.
Summing The Strategy Up.
The long term diagonal spread or poor man’s covered call is an excellent strategy to use in low volatility environments as the long call at the outset of the trade will invariably gain value quicker than the short call. Furthermore the long term diagonal spread strategy is excellent for traders with limited capital as one can spread their capital across a larger range of stocks and ETF’s which increases diversification. Whereas strict option traders normally only monitor volatility and liquidity, I would encourage you (before picking your underlyings) to also monitor sentiment, valuation and momentum indicators. Here is how things would shape up with one of the stocks currently on our watch-list – L Brands.
1. Momentum Indicators Oversold
2. Sentiment On The Floor In L Brands.
3. Volatility High As Earnings Approach
In an earlier post, we went through how cheap L Brands is when compared to its historic valuation. The issue here though is implied volatility. As earnings are expected to be announced shortly, this explains why implied volatility in the stock is over 40% which is well above its 12 month average. One could wait until earnings have been announced before adopting the long term diagonal spread strategy as a post earnings “L Brands” would have far lower volatility levels which would suit this strategy. However by waiting, the trader runs the risk of missing a big move after earnings are announced. This is why in the stock market, no matter how much you follow a mentor, ultimately the buck stops with you when it comes down to decisions like this.