Real-World Trading: The Diagonal Spread, Part 2

However, it's still unclear if the merger will get approval and, if so, when it will occur. This uncertainty has created a nice trading opportunity for option traders.

As of last Tuesday's close, Dreyer's sat at $60.31. That's a far cry from the takeover price, but is much higher than $45, where it traded before the merger announcement. So, let's construct a diagonal spread and then discuss the possible risks to this trade.

• April 15, 2003

• DRYR @ 60.31

• Sell 1 May03 65 Call @ 4.75

• Buy 1 Sep03 75 Call @ 1.45

• Net Credit = 3.30 or $330 per spread

• Max Risk = -528.95

• Break Even = 91.25

Below is a risk graph for this trade. Remember, the risk graph is showing the results of the trade only through May expiration. Our profits could be much higher over time as we sell more options, or if we hold on to the long option and it gains value before September expiration.

This isn't a typical diagonal spread graph: The reward is good, though the risk is virtually nothing. Our maximum profit would be achieved if Dreyer's trades at $65 at the May expiration. This is because we'd keep the entire credit of $330, but the Sep03 75 call would still have value. This trade works out so well because the implied volatility of the May option is now at 91.3, with the September option showing IV of just 32.8. The break-even point is so high because we have taken in a credit of $3.30. This means that the stock has to rise to about $91 before we would incur a loss. This could happen, but isn't likely, as the takeover price (if approved) is only $83.

Once May expiration comes, we could re-evaluate the position to see if we want to sell June options as well. As time passes, the time frame for the merger decision will become clearer. If after May expiration we feel the merger is likely to happen, we'd be best served to hold our long option. If the stock does rise to $83, our September call would have a minimum value of $8, which would be in addition to the $3.30 we originally took in.