Step1,
Another way to look at the diagonal spread, from another example view. In all cases, Black-Scholes is used with the Implied Volatility set the same as the September 37 calls.
Take the example I gave in the previous response and assume I was wrong about QQQ staying about even or moving slightly up over the next 6 months and it moves down steadily. Each time I sell an option against my long Jan 05 32's, the stock moves steadily downward and the short options expire worthless, but the stock declined to the point I only break even.
Look at what it takes:
Buy January 05 32's for $6.40
Sell September 37's for $1.70, net $4.70 (Less than $5 strike spread.)
QQQ closes at $35.5 on expiration in September, with the long January 32's worth $4.70, breakeven. The short calls expire worthless. On Monday, I:
Sell November 35's for $1.70, net $3.00 (Equal to the $3 strike spread.)
QQQ closes at $34.25 on expiration in November, with the long January 32's worth $3.00, breakeven. The short calls again expire worthless. On Monday I:
Sell December 34's for $1.00, net $2.00 (Equal to the $2 strike spread.)
QQQ closes at $33.40 on expiration in December, with the long January 32's worth $2.00, breakeven. The short calls again expire worthless. On Monday I:
Sell the January 32's for $2.00 and breakeven. (excepting transactions costs, which are not trivial, but are ignored for this example.)
Over a 6 month period, I have taken a slightly bullish position and I broke even with a steady fall of almost 10%.
The long position, offset by the short one, gives you some downside protection, at the cost of giving up the "homerun" gains on the upside. But for making sure the house payment, insurance, groceries and other monthly bills get paid, it is, as I said, one of the most consistent cash generators because of the premium flow from short calls.
Ira |
