36 lines
2.8 KiB
Plaintext
36 lines
2.8 KiB
Plaintext
Chapter 14: Diagonalizing a Spread 239
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In summary, the diagonal bull spread may often be an improvement over the
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normal bull spread. The diagonal spread is an improvement when the stock remains
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relatively unchanged or falls, up until the near-term written call expires. At that time,
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the spread can be converted to a normal bull spread if the stock is at a favorable price.
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Of course, if at any time the underlying stock rises above the higher striking price at
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an expiration date, the diagonal spread will be profitable.
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OWNING A CALL FOR "FREE"
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Diagonalization can be used in other spread strategies to accomplish much the same
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purposes already described; but in addition, it may also be possible for the spreader
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to wind up owning a long call at a substantially reduced cost, possibly even for free.
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The easiest w~y to see this would be to consider a diagonal bear spread.
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Example: XYZ is at 32 and the near-term April 30 call is selling for 3 points while the
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longer-term July 35 call is selling for 1 ½ points. A diagonal bear spread could be
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established by selling the April 30 and buying the July 35. This is still a bear spread,
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because a call with a lower striking price is being sold while a call at a higher strike
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is being purchased. However, since the purchased call has a longer maturity date
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than the written call, the spread is diagonalized.
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This diagonal bear spread will make money ifXYZ falls in price before the near
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term April call expires. For example, ifXYZ is at 29 at expiration, the written call will
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expire worthless and the July 35 will still have some value, perhaps ½. Thus, the prof
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it would be 3 points on the April 30, less a 1-point loss on the July 35, for an overall
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profit of 2 points. The risk in the position lies to the upside, just as in a regular bear
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spread. If XYZ should advance by a great deal, both options would be at parity and
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the spread would have widened to 5 points. Since the initial credit was 1 ½ points, the
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loss would be 5 minus 1 ½, or 3½ points in that case. As in all diagonal spreads, the
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spread will do slightly better to the downside because the long call will hold some
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value, but it will do slightly worse to the upside if the underlying stock advances sub
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stantially.
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The reason that a strategist might attempt a diagonal bear spread would not be
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for the slight downside advantage that the diagonalizing effect produces. Rather it
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would be because he has a chance of owning the July 35 call - the longer-term call -
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for a substantially reduced cost. In the example, the cost of the July 35 call was 1 ½
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points and the premium received from the sale of the April 30 call was 3 points. If
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the spreader can make 1 ½ points from the sale of the April 30 call, he will have com
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pletely covered the cost of his July option. He can then sit back and hope for a rally |