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Strategies & Market Trends : Options 201: Beyond Obi-Wan-Kenobe -- Ignore unavailable to you. Want to Upgrade?

To: Step1 who wrote (1024)	6/13/2004 6:43:48 PM
From: Ira Player	Read Replies (1) \| Respond to of 1064

Hi Step1, I primarily use diagonal spreads to buy intrinsic value and sell extrinsic (time) value. I break the generally accepted rules in that I leg into most positions, trying to buy the long call on short term weakness and trying to sell the short call on short term strength...It can burn you because you are naked long for a period of time without the short as a hedge, but has worked for me most of the time. With GFI, the difference between the strikes is 2.50 and the net premium paid is 1.35, so it meets the criteria I stated. However, I tend to buy a little more in the money and sell nearly at the money to lower my "break even" point. In your case, if implied volatility remains constant, break even is about 10.65 at October expiration of the short call. So, the stock has to rise by almost 3% in 4 months for you to break even... If it closes above 12.5 (a 20.5% rise), your return is about 80%...pretty good, but you better be confident in the direction of the stock. I like a little more downside protection... I prefer further in the money long calls and nearer the money short. I give up on percentage return, but have more victories because of better downside protection. I also stick with high liquidity options and prefer higher priced underlying because the bid/ask spread is smaller percentage wise. An example: (Not one I'm doing or recommending, just for reference) With QQQ at $36.84 on Friday I might: Buy the January 05 32 call for $6.40 ($1.56 time) Sell the September 05 37 call for $1.70 ($1.70 time) Net is $4.70. Breakeven is at QQQ of $35.5 at September expiration, a DROP of a little over 3.6% If it drops a few points early in the spread and I believe (by whatever crystal ball I'm using at the time...) that it is a short term drop and will recover, I might buy the Sept 37 back, if I can get it for less than half what I got for it. Even if it drops a little as September expiration is approaching, I can soon sell the Octobers, Novembers or Decembers against the long call, which now has a "basis" of $4.70, pulling in further premiums. If it rises, I have the option to "roll them up" by buying back the 37's and selling a higher strike instead. It increases the basis, but (if I'm confident the rise will hold) gets back some of the 'lost' gain of the rise. If, for example, I had opened the position at some point earlier by selling the Sept 35...I could buy back the Sept 35 for 3.10 and sell the Sept 37 for 1.70, effectively getting $2 for the 1.40 net investment. I don't use calendar spreads looking for home runs, like 80% in 4 months, I'm looking for good rental properties with consistent cash flow to live on. And like all rental issues, you have to keep an eye on it and take appropriate corrective actions, depending on the action of the market. Ira

To: Step1 who wrote (1024)	6/13/2004 7:22:38 PM
From: Ira Player	Read Replies (1) \| Respond to of 1064

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