Tuesday, June 5, 2012

How to Screw up a Diagonal Spread $aapl

#6 and #7  is new:

ive posted previously about diagonal spreads and my reasoning for entering them. Now here are some ways for you to screw it up, use an $AAPL 2014 500call vs July2012 600short call as an example:

1. You have to remember the goal of a diagonal spread. again the purpose is to capture that monthly premium of that short call..the july2012..going for $11.50 this moment... your thought process should be exactly the same as why you would buy stock and then sell an upside call. the day to day, week to week movement of the stock is irrelevant..YOU HAVE 1.5 YEARS OF STOCK MOVEMENT AHEAD OF YOU. there will be several periods of "oh shit, the market will crater" and several periods of "this stock is going to 1000" hysteria. if you can not understand this basic thought process then do not enter diagonals and go back to the day trading.

2. Closely related to #1, is not having patience. Diagonals are the epitomy of a non sexy trade, you dont see the twitter stream filled with traders boasting about how they got in and out of the diagonals for some Kachingas..Im sorry, but you may actually have to have a time frame longer than the end of this week to realize a profit..oh damn, you might even have to wait 3 weeks for the time decay of that short call to erode.

3. Overtrading - because you should ignore what the value of your 2014call is, you can sometimes trade around that short call..so if stock drops you can buy back the short call for profit, roll it into a ratio spread if there is enough time left in month. such as you sold the short call for $14..stock drops with market and this call is now worth $3..you are up 80% or so of max profit on this short call...you could buy it back and put on a ratio spread for expectation of rebound till opex..many times the ratio will profit more than the $3 you could have gained by holding the short call the rest of the way. Or you might have a thesis that stock rebounds and you do nothing and if stock rebounds then you resell the same short call or even a lower strike call for premium again...But where you can screw this up is trying to day trade this short call, selling at $14, buying back at $12 for $200 ..you are leaving $1200 on the table that time decay can work on in hopes that it will rebound.  if you are considering buying back the short call you need to think of it in a 2step process..buying back the call is step 1, but what is step 2?? what are you going to do next? just be naked long the 2014calls? thats ok..but you need to think thru what comes next...buy back call to put on ratio spread? buy back call and sell next months call? whatever...but just buying back the short call without figuring out next step is a mistake

4. Diagonals are the type of trade that you put on and dont have to watch your quotes all day. you dont do it for your stock covered calls. just need to relax.. just chill. Chillax. if you cant handle the ups and downs while laughing all the way to the bank on those juicy monthly premiums, then maybe you should stick to mutual funds or index ETF's

5. Getting shaken out on the upside, ive been yapping about the July600short call near $13 ($1300)..  AAPL is up on spain news and the july600short call is at $15ish (a $200ish paper loss). another way to screw up the diagonal spread is a combination of #1,2,and 3.. so now you are thinking, "damnit, i just capped my gains by selling that upside short call, because Cramer is bullish again for the next 45minutes, i need to let that Leap run". before you do something stupid, put some facts and numbers behind your thoughts. using the Trademonster Analyse tab, you can get a decent approximation of where your breakevens are on the upside and downside of a move. entering in the Jan2014 500long call and the July2012 600short call and adjusting the numbers..but first, it doesnt take a profit calculator to figure out where your breakeven on the july600short call will be...it will be at $613..you sold it for $13 and it will be worth $13 at opex if stock is at $613. but look how much your Leap has gained from 585 right now to 613. if stock continues higher your short call loses money but Leap is gaining money..now using the analyse tab, you can figure your upside breakeven for the entire "position" is near 700 at july opex...thats crazy..so stock can go up over 100points and you do not lose money. point being, if stock goes up (fyi, stocks go up and down and will continue to do so) dont just focus on that short call and freak out and decide you are losing money. come opex time you can just roll that short call to next month, there will be decent time premium from the roll that you will gain. so let that time decay do its thing and relax..relax on upside, relax on downside. too easy

6. A quick way to screw this up is to pick strike prices incorrectly. with stock at 605ish now..you will eventually get the thought in your head along these lines "instead of paying a huge amount of money for that Jan2014 call, i can instead pay alot less and just buy the 600 strike call".. sure thats true. heres the downside, if the stock drops back lets say to 550, in order to NOT have to commit more margin to the trade you can only sell front month 600 short calls..essentially making this trade a series of calender spreads instead of diagonal spreads.. thats ok but you need to be aware that trying to sell a short call below 600 (your long LEAP strike) is going to cost you much more margin. also, putting on ratio spreads will require additional margin. by only being able to sell the 600 strike short calls, you may have to settle for some low premium strikes for some months waiting for the stock to rebound.

7. An essential part of my diagonal spread strategy is that my Long LEAP call is as far out in time as possible.. im not going to try to get cute and buy a Dec 2012 call.. giving me only 4-5 months of repeated short call selling.. never know, maybe we get a prolonged sideways or down market..going out to max time gives me plenty of time to recover.. the goal is capturing time decay of the short calls and getting some price appreciation of the LEAPS.. just like if you had stock covered calls...you want to see your stock go up a bit each month and capture that short call premium. so the point of this one is to buy that DITM Leap out as far as possible, pay a bit more to get that added time.

on twitter


  1. this is exactly what i did with aapl july 600 calls sold @ $17 against my jan 500 2014 leaps.when aapl dropped the other day bought back the 600 july call for $1340 thought aapl would rebound and i could then see the same july 600 call for $15.50(5)but aapl only had one run up yesterday and sold july 600 @ $13.50 was just a waste of time- did not want to just hold any leaps without calls sold against them

    1. yes, you did waste your time


  3. Wow this post really give me a strong insight how diagonal spread work. This is perfect for people who don't trade a lot and the money potential is great. Great stuff keep it going.