35 lines
2.6 KiB
Plaintext
35 lines
2.6 KiB
Plaintext
Chapter 14: Diagonalizing a Spread 231
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bull spread would be similar except that one would buy a longer-tenn call at the lower
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strike and would sell a near-tenn call at the higher strike. The number of calls long
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and short would still be the same. By diagonalizing the spread, the position is hedged
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somewhat on the downside in case the stock does not advance by near-term expira
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tion. Moreover, once the near-term option expires, the spread can often be reestab
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lished by selling the call with the next maturity.
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Example: The following prices exist:
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Strike April Ju~ October Stock Price
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XYZ 30 3 4 5 32
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XYZ 35 11/2 2 32
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A vertical bull spread could be established in any of the expiration series by buying
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the call with 30 strike and selling the call with 35 strike. A diagonal bull spread would
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consist of buying the July 30 or October 30 and selling the April 35. To compare a
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vertical bull spread with a diagonal spread, the following two spreads will be used:
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Vertical bull spread: buy the April 30 call, sell the April 35 - 2 debit
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Diagonal bull spread: buy the July 30 call, sell the April 35 3 debit
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The vertical bull spread has a 3-point potential profit if XYZ is above 35 at April expi
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ration. The maximum risk in the normal bull spread is 2 points (the original debit) if
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XYZ is anywhere below 30 at April expiration. By diagonalizing the spread, the strate
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gist lowers his potential profit slightly at April expiration, but also lowers the proba
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bility of losing 2 points in the position. Table 14-1 compares the two types of spreads
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at April expiration. The price of the July 30 call is estimated in order to derive the
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estimated profits or losses from the diagonal bull spread at that time. If the underly
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ing stock drops too far - to 20, for example - both spreads will experience nearly a
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total loss at April expiration. However, the diagonal spread will not lose its entire
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value if XYZ is much above 24 at expiration, according to Table 14-1. The diagonal
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spread actually has a smaller dollar loss than the normal spread between 27 and 32
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at expiration, despite the fact that the diagonal spread was more expensive to estab
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lish. On a percentage basis, the diagonal spread has an even larger advantage in this
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range. If the stock rallies aboye 35 by expiration, the normal spread will provide a
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larger profit. There is an interesting characteristic of the diagonal spread that is
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shown in Table 14-1. If the stock advances substantially and all the calls come to par
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ity, the profit on the diagonal spread is limited to 2 points. However, if the stock is
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near 35 at April expiration, the long call will have some time premium in it and the |