Trading Diagonal Spreads (Part Two)

01/20/2010 12:01 am EST

Focus: OPTIONS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

John Jagerson of Learning Markets shows the steps for entering a diagonal spread trade.

In the second article of this series on selling covered calls against LEAPS, or diagonal spreads, I will begin walking through the entry process with a case study. The numbers and real-life scenario should help you understand how these trades work and why they are attractive, but if you really want to remember the information, you should paper trade it a few times yourself. Going through the process by hand will help you remember the process.

In the case study, I will use an index option with European-style expiration. This solves the problem of early exercise that I mentioned in the first part of this series.

Because European-style options can only be exercised at expiration and not before, the index option I will use is the mini SPX index option (XPS). The XPS, or mini version of the SPX, is good for smaller traders as the options are only one-tenth the price of the normal SPX options.

You can find more information about trading short options and covered calls below.

Step 1: Buy the Long-Term Option

First, we need to buy the long-term option at least a year out before expiration. In the case study, this means buying the December 2009 calls.

The long-term options purchased can be very far in the money if you wish, but I typically suggest buying one strike price in the money. Assuming a current XPS price of $93, that means I would buy the $90 strike price calls for $1,615 per contract.

Step 2: Selling the Short-Term Option

In my experience, buying a far-in-the-money long-term call does not materially impact returns compared to a call that is very near to the at-the-money strike price.

What is important, however, is that in the next step, you sell a short-term call with a strike price above or further out of the money than the call you bought. In this case, that means I would sell the December 2008 95 strike price calls for $535 per contract. The rate of return just based on those prices is more than 30%. Of course, risk and time value will eat away at that best-case scenario.

At this point, the trade looks very similar to a covered call. The long-term option takes the place of the long stock and protects against the unlimited losses that may occur with a short option alone. In the next section of this series, I will cover what happens if you are "called out" of a trade like this at expiration.

By John Jagerson at LearningMarkets.com

Learning Markets offers daily articles, videos and investing guides—for free—about everything from investing in stocks and options to trading currencies in the forex market and more. Visit LearningMarkets.com to learn more about investing and to interact with other investors just like you.

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