Part #3 of 4 – Using SPX Options in a Diagonal Spread

Back in May and June we posted two videos on using Index options and SPX Super LEAPS®, this is the third in a four part series on using SPX Index options. You can watch the previous videos by visiting http://www.cboeoptionshub.com/author/shawn-howell/

For this third segment I’m using the SPX LEAPS and Super LEAPS as a foundation for a Diagonal Spread selling, SPX Weeklys to offset time decay or as an income generating strategy.

Here’s the general premise, as discussed in the first video when interest rates are low and we buy an option with a long expiration, the cost of time is much lower than if we bought a near-term option. In our example April 23 the SPX was at 1875 and buying an at-the-money option expiring December 16, 2016 would cost $17,200*. With 968 days to expiration this amounts to a daily cost to carry this option of $17.77 using a straight-line calculation for time decay.

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A trader that takes this position is anticipating that the SPX index will rise and the price appreciation of the option will outpace the time decay. As you can see, as of July 27th the SPX is at 1975 and our SPX LEAPS that we paid $17,200* for is now worth $22,470. As a side note, the index is up 5.3% and the option is up 31%. This is a good example of leverage afforded to us through options.

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Although the SPX has had a strong run up since April 23, the past 30 days there is evidence of overhead resistance around the 1990 level.

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The SPX has made three runs at the 1990 level in the past 30 days with the highest close on 7/23/14 at 1987. From a technical perspective this indicates the market might be losing some of its’ upside momentum. This is not necessarily a bearish sign but it might indicate that the market will stagnate at this level for awhile. If the market remains at this level we will see two things happen. The first is the effects of time decay. Since time is money and the underlying isn’t increasing in value, time decay will slowly reduce the value of our long call. If the market stays at this level and volatility declines, the drop in volatility will further reduce the valuation of our long leg. This technical behavior creates an opportunity to discuss “legging in” to a diagonal spread using an SPX Weekly. A diagonal bull call spread is one in which a short-term call option (typically at a higher strike) is sold against a longer-term call option to produce income or offset the effects of time decay, or both.

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The option chain above is for the SPX Weeklys. Note the time to expiration is five days and that the SPX Weeklys just like the SPX LEAPS settle in “Cash” and are European. This is important as we don’t have to concern ourselves with early assignment or of having our long leg “called” away (assuming the account has the funds to settle any in-the-money amount upon expiration). The details for the Aug 2 1990 Call are shown above. At the time the screen shot was taken this contract is $10.80 out the money and a few points above the highest close of the SPX (resistance). Therefore the current bid of $3.50 is nothing but extrinsic value (time value). To arrive at the “value” of time per day in this Weekly option we take the Bid value per contract $350/5 days to expiration. This option is priced at $70 per day. Remember that for our SPX Super LEAPS we are paying @ $18 per day for time; leaving the position Theta positive $52/day. Therefore, if we sell the SPX Weekly 1990 call we receive a credit of $350. During the next five days I can anticipate that the SPX LEAPS in my portfolio will decay $90 and the SPX Weekly will decay $350 leaving me with a theoretical “profit” of $260*. I’m selling time at a higher value than what I am buying time for or what I call “theta arbitrage”. Under these circumstances the overall position (assuming the index remains flat for the next 5 days) will yield 1.15% in five days time. Not only have I completely offset the effects of time decay, the position is also generating income.

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Of course it’s not likely that the SPX will stay perfectly flat over the next 5 days. In fact, based on the overall trends I have built in just over 10 points of upside cushion in this position. As we know, the market can move in three directions over the next five days, up, down and sideways.

Let’s take a very basic look at the three scenarios to understand how the diagonal might play out.

SPX moves higher but stays below 1990:

If over the next five days the SPX were to move higher but remain below the 1990 upon expiration then the short leg will expire worthless. The trade will revert back to being a Long Call and the $350 credit remains in the account. Keeping the $350 credit is nice but the real value in this move is the increase in the intrinsic value of the long leg.

SPX moves slightly lower but not enough to prompt closing the SPX LEAPS:

Although the value of the Long leg has decreased by the drop in the underlying, some or all of the loss in value is made up by the expired short leg’s $350 credit.

SPX stays at the same level:

Since the index has neither increased nor decreased, the value of the long leg will have decreased primarily due to time decay. However, as explained earlier the time decay on the long leg is much less than the time decay on the short leg as the $350 credit more than offset the anticipated $90 decay for the long leg over the same period.

That’s the general set-up for the Diagonal Spread. Diagonal Spreads are a wonderful strategy and easy enough to put on. The real challenge of the strategy (especially using Weeklys) is the required maintenance of the position. Most weeks the trader will need to decide what to do next, will he roll the position and if so, will he roll out, up or down? Will he close out the position entirely or will he keep just the long leg for the time being? This required maintenance can be stressful and with stress comes emotions and emotions produce irrational trading decisions. The greatest benefit of the diagonal is flexibility; this is also the greatest challenge for the trader since there are so many ways he can take the trade. Next week I will discuss some of the choices as this trade matures and post the final segment to this series. I will also discuss Gamma risk and the myriad of “rolls” a trader can make.

We consider diagonal spreads to be a more intermediate strategy and we assume some of our more rookie traders may have been lost along the way. If you are one of these traders and would like to reinforce/refresh your knowledge of basic option strategy with us at Pro Market Advisors, contact us.  We have an Essential Options Online Course, designed for the novice option trader to bring his/her understanding of options up to a level that the strategy above would be actionable.

*None of the examples include commissions and fees.

 

Shawn Howell