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Real-World Trading: The Diagonal Spread, Part 2

One strategy is to sell a lower-strike call and buy a higher-strike call.

Last week I discussed the details of a diagonal spread. This strategy is similar to a calendar spread, but instead of selling and buying the same strike, you're selling a strike that's different from the one you buy. Different traders use different techniques for diagonal spreads, with diversity a key component of using this strategy.

Some traders prefer to sell a higher-strike call and buy a lower-strike call. You'd want to find at least a 15% skew between these options before entering a diagonal on them. The idea behind selling the higher-strike call is that you have room for short-term growth. For example, if you buy a 20 strike call and sell a 25 strike call, the long call can gain $5 before expiration, and you still get to keep the entire premium from the sold option. However, this also means that you aren't going to get a lot of premium up front, because the sold option is further out of the money.

Another strategy is to sell a lower-strike call and buy a higher strike. In this case, you can often even get a credit, with the risk being that the stock moves above the short call before expiration. We'll use this strategy for our mock trade this week.

Last week I showed a graph of

Dreyer's Grand Ice Cream

(DRYR)

as an example of a diagonal spread. I searched Tuesday for candidates for a diagonal trade, and Dreyer's was listed over and over. Therefore, I decided to use this stock for our mock trade.

Dreyer's is showing a large skew between option months because of an impending takeover by

Nestle

. The merger announcement was made last June, but the proposed deal has been experiencing regulatory problems. If the merger is approved, Dreyer's shareholders would get about $83 a share for their stock.

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.

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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.

Because there is perceived risk between the sold option and the purchased option of 10 points, your broker will probably want margin to cover this risk. However, this margin should be offset by the initial credit. Let's assume the stock gets a boost from the merger's approval and we get assigned on our short 65 call. Let's say the stock is trading for $80, so we'd have to sell 100 shares of stock to the exerciser for $65 a share.

We'd need to go out into the open market and buy 100 shares at $80, totaling $8,000. The theoretical price of the Sep03 75 call would be about $9.25, plus we initially got $3.30. Thus, we would still have a profit, even though we were assigned. This is why the break-even point is so high.

Please feel free to

visit my forum and enter your comments and concerns.

By Jody Osborne, senior writer and options strategist at

Optionetics.com.