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Our previous article on the diagonal spread trade pointed out how this strategy incorporates the best features of the vertical spread and the horizontal spread while avoiding some of the drawbacks of each. In the previous article, the diagonal spread trade was illustrated with Procter & Gamble (PG) call options. It was also discussed how the trade could be continued forward by utilizing weekly options. The discussion here provides an update on the original diagonal spread and indicates how it could be continued forward toward the July 19 expiration date. In early June with PG trading near $78, it was anticipated that the stock price might be moving up over the next six weeks in anticipation of a strong earning report on August 1. To guard against some time loss in a long call option while waiting for the stock to move up, a diagonal spread with PG call options was selected. Original Trade (6/11): Buy 1 July (monthly) 75 call for $3.60 and sell 1 June (monthly) 80 call for $.35 for a net cost of $3.25. First Continuation (6/21): With PG trading around $77.50, the June (monthly) 80 call expired worthless. The June (weekly exp 6/28) 80 call was sold for $.15, reducing the cost basis of the July (monthly) 75 call down to $3.10. Second Continuation (6/28): With PG trading around $77, the June (weekly exp 6/28) 80 call expired worthless. The July (weekly exp 7/5) 80 call was sold for $.10, reducing the cost basis of the July (monthly) 75 call down to $3.00. Third Continuation (7/5): With PG trading around $78.50, the July (weekly exp 7/5) 80 call will expired worthless. The July (weekly exp 7/12) 80 call was sold for $.25, reducing the cost basis of the July (monthly) 75 call down to $2.75. Outlook (7/5 to 7/19): By selling weekly calls every Friday beginning with 6/21, the original cost of the July (monthly) call has been reduced from $3.60 down to $2.75 while waiting for the price of PG stock to move up. This continuation with weekly options has produced a profit when simply holding the long Jul 75 would currently reflect a small loss. Moreover, it has not been necessary to abandon the original viewpoint that PG stock would make a move up as we progress toward the expiration our July 75 call on 7/19. By continuing the diagonal spread with the selling of weekly options, sufficient compensation has been achieved to offset the time value lost in the long July (monthly) call. If at any time along the way, there had been a surge in the PG stock price to a level above $80, the diagonal spread could have been closed for a nice profit. Selling weekly options also allowed for a frequent re-evaluation of the long position to see if an early exit seemed appropriate. ****************************************************************************************************** Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education and trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.

The diagonal spread offers a great compromise between the vertical spread and the horizontal spread. It incorporates the best features of each while avoiding some of the drawbacks of each. Let's briefly review the vertical and horizontal spreads including the shortcoming of each. For the discussion here, we will consider only debit spreads. VERTICAL SPREAD You buy a Call (Put) that has a delta of magnitude .45 to .65. Then you sell a Call (Put) with a higher (lower) strike price. Both Calls (Puts) will have the same expiration date. Ideally, you want the sale price of the short option to lower the cost of the long option by at least 30%. The Vertical Spread achieves its maximum return at expiration when the price of the underlying stock has moved beyond the strike price of the short option. Shortcomings of the Vertical Spread: Must wait until the expiration of both options to achieve the best profit. Profit is limited to the difference between the two strike prices less the net cost of the spread. HORIZONTAL SPREAD (also called a calendar spread or time spread) You buy a Call (Put) with a strike price that is near the current stock price. The expiration date of the long Call (Put) is typically 4-8 weeks in the future. Then you sell a Call (Put) with the same strike price and a closer expiration date. Ideally, you want the sale price of the short option to lower the cost basis by at least 30%. The Horizontal Spread achieves its maximum return if the stock price is very near the common strike price when the short Call (Put) expires. Shortcomings of the Horizontal Spread: The stock price must be very near the common strike price at expiration in order to have a reasonable profit. If the stock price is even modestly removed (up or down) from the strike price, the spread is unlikely to produce a profit. Must be wary of any event (earnings report, etc) that might cause a large move in the stock price prior to the near term expiration date. DIAGONAL SPREADS The compromise between the Vertical Spread and the Horizontal Spread. You buy a Call (Put) that has a delta of magnitude .45 to .65. Then you sell a Call (Put) with a higher (lower) strike price that has a closer expiration date. The Diagonal Spread has the advantage of directional movement offered by the Vertical Spread, while also providing the relatively quick expiration of the short option offered by the Horizontal Spread. If weekly options are available, there is substantial flexibility in selecting the time frame over which the trade can be maintained. ILLUSTRATION USING PROCTER & GAMBLE (PG) To illustrate the diagonal trade, let's consider a current trade on a popular Dow stock, Procter & Gamble Co (PG). Example Trade: In early June, PG was trading at $78 after a modest pullback. With an earnings report due on August 1, it was felt that PG would likely be moving up over the next six weeks. Trade: One July (monthly) 75 call was purchased for $3.60 and one June (monthly) 80 call was sold for $.35. Net cost of the trade was $3.25. Comment: Note that the premium received from the sale of June 80 call reduced the cost basis by about 10%, which is significantly less that what would be expected in a vertical or horizontal spread. The diagonal spread is typically more expensive than a vertical or horizontal spread, but that is offset by the potential to benefit from a quick directional move. Trade Evaluation: On the expiration date of the June (Monthly) 80 call, the trade will be at break-even or better if PG is above $77.50, and will show a profit of at least 40% if PG is above $79. If PG is at $80 or higher, the trade will have a profit of about 60%. Comment: At the June expiration date with the stock at $80, the July (monthly)75 call by itself would show a profit of only 46%. Trade Continuation: If PG has not reached $80 when the June expiration date arrives, the June (monthly) 80 call will expire worthless and the July (monthly) 75 call will have a reduced cost basis of $3.25. This option can then be held for unlimited future gains. Since PG has weekly options, there is an opportunity to continue this trade on a week-by-week basis as you wait for the PG stock price to move up. The premium received from the sale of a weekly call can help offset the time decay in the long option until PG makes its move. Trade Continuation with weekly options: If PG is below $80 at the June (monthly) expiration date, the June weekly 80 call might be sold for $.25. This will reduce the cost basis of the July (monthly) 75 call to $3.00 while still allowing for plenty of upside potential for a profit. Management of the Diagonal Spread: The key to the diagonal spread is keeping track of the deltas of the two options. When the trade is initially established, the short option will be out of the money and have a delta of lower magnitude than the long option. If the underlying stock moves quickly and extensively in the desired direction, it is possible for the delta of the short option to outpace that of the long option and even lead to a losing trade. This is the same problem seen in a horizontal spread. When setting up the trade, it is wise to consult a risk graph to determine the most extreme move of the underlying stock that will still yield a worthwhile profit in the diagonal spread. It may be necessary to move the strike price of the short option further out-of-the-money in order to guard against a losing trade when the underlying stock moves farther than anticipated. What stocks are most suitable for diagonal spreads? Stocks that offer numerous strike prices are best. This permits flexibility in selecting an option to short that will yield a reasonable premium while still allowing for ample price movement. Also, as mentioned above, stocks that have weekly options provide additional flexibility to adjust the trade regularly in response to price movement. ****************************************************************************************************** Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education and trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.

Dr. W. Edward Olmstead Olmstead Options Trading Strategies The basic goal of a calendar spread (also called a horizontal spread) is to sell a near-term option to collect premium in order to lower the cost basis of a longer-term option with the same strike price. The calendar spread can done with either calls or puts. The basic concept for this trade to be profitable is that the near-term option will lose all of its time value while the longer-term option retains a significant portion of its time value. Unfortunately, the profitability of this strategy also requires the price of the underlying stock to be sufficiently close to the common strike price as the near-term option reaches its expiration date. In the traditional version of the calendar spread, a front-month option is sold against a more distant monthly option with the same strike price. Holding this version of the trade for several weeks while waiting for the front-month option to lose its time value can become very frustrating as you watch the price of the underlying stock drift far from the common strike price into a range that is likely to produce a loss at expiration. Now that weekly options have become available on many stocks (and ETF’s), there are new opportunities for the calendar spread trader. It is no longer necessary for the near-term option in a calendar spread to be the front-month option. The short, near-term option could be a weekly option that expires in nine days or less. While a smaller premium is received from selling a weekly option, there are some compensating features that make this new version of a calendar spread worthy of consideration. By selling a weekly option, the opportunity to exit the trade arrives much sooner. When all of the time value in the weekly option has quickly decayed to zero, very little time value will have been lost in the long-term option. This offers the possibility of a quick exit for a profit that might be small, but also frees up capital to move on to a new trade. Even though a smaller premium is received from selling the weekly option, the possibility of repeating the process over 3-4 weeks could easily provide a total premium in excess of that received from the one-time selling of a front-month option. Here again there is the opportunity to close the trade at the end of any week in which it appears unwise to continue holding the long position. With a weekly option as the near-term component in the calendar spread, it becomes easier to convert the calendar spread into a diagonal spread. As one weekly option expires, it may be advantageous to roll into a new weekly option with a strike price that is further out-of-the-money. This might open up the opportunity for a bigger long-term profit if the price of the underlying stock keeps moving in a direction that favors the long-term option. There are currently well over 100 stocks and ETFs that trade weekly options. Popular stocks that have weekly options include, AAPL, AMZN, FB, GOOG, JNJ, QCOM and YHOO. Heavily traded index ETFs with weekly options include DIA, IWM, QQQ and SPY. Your broker should be able to provide a complete list. Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.