Investors who want to participate in this market can use options to limit their risk to an adverse move. Late last week when the US debt deadlock was at its peak, there was a strategy that our investors used in anticipation of a jump in the market, and today we’ll examine this strategy in detail.
The S&P/ASX 200 pulled back nicely in the early part of October, down to its 200-day moving average. Markets have a cyclical tendancy to drift lower into early October and if you wanted to trade for a potential reversal the Diagonal Bull Call Strategy offers a defined-risk way to trade.
There were also a number of reasons why a long term investor may not have wanted to jump into an outright stock position in a market where there was the possibility of a US debt default.
Diagonal Bull Call Spread Strategy
The Diagonal Bull Call Spread is a cheaper alternative to buying the stock outright and is a neutral-to-modestly-bullish options strategy that profits when the underlying stock trades sideways or modestly higher. By using this options strategy, you can limit the cost of the exposure to a stock, while also limiting the risk in holding this position – the downside is a limited exposure to a sharp up-move.
In this article we outline this simple Diagonal Bull Call Strategy which entails buying long-term calls In-The-Money (ITM) and simultaneously writing an equal number of near-month Out-of-The-Money (OTM) calls of the same underlying stock with a higher strike, to participate in profits when the underlying stock price initially trades sideways or modestly rises and is expected to continue higher longer-term. This is classified as a Vertical Call Spread.
A Diagonal Bull Call Spread Strategy profits primarily from the difference in rate of time decay in the option premium, between the near-term short options and the longer-term option. This is possible as near-term option premiums decay faster than longer-term option premiums.
You should use a Diagonal Bull Call Strategy when you want to profit from an underlying asset that is expected to trade sideways or trade modestly higher and want to take a bullish position on the stock in the longer term.
The Diagonal Bull Call Strategy is very flexible and provides a limited risk of exposure to the underlying stock. The strategy allows you to profit from an underlying stock price which is rising and/or falling modestly or trading sideways, gaining a leveraged bullish position if the short option expires worthless.
Profit Potential of Diagonal Bull Call Spread
The ideal situation for the Diagonal Bull Call Spread buyer is when the underlying stock price remains unchanged and only goes up towards the strike price of the call sold when the long term call expires. In this scenario, as soon as the near-month call expires worthless, the options trader can write another call and repeat this process every month until expiration of the longer term call to reduce the cost of the trade. If you can write over your long position a number of times, it may even be possible at some point in time to own the long term call “for free”.
The Diagonal Bull Call Strategy spread reaches its maximum profit when the underlying stock closes just below the strike price of the short call options at expiration of the short call options. Under this ideal situation, maximum profit for the diagonal bull call spread is obtained and is equal to all the premiums collected for writing the near-month calls plus the difference in strike price of the two call options minus the initial debit taken to put on the trade.
The value of a Diagonal Bull Call Strategy during the course of the trade and prior to the expiration of the short call options can only be arrived at using an options pricing model such as the Black-Scholes Model, because the expiration value of the longer-term call options can only be arrived at using such a model. Equally the breakeven point of a Diagonal Bull Call Strategy is the point below which the position will start to lose money if the underlying stock rises or falls strongly and can only be calculated using an options pricing model.
In summary, the keys to the risk/reward of a Diagonal Bull Call Spread at expiry are:
* the upside maximum profit is limited
* the maximum loss is limited (limited to net debit paid)
Limited Downside Risk
For the trader of this type of strategy, the maximum risk is limited to the initial premium paid for the Diagonal Bull Call Spread. This happens when the stock price goes down and stays down until expiration of the longer term call. However the maximum profit is also limited.
Time decay is the enemy of most options traders, particularly those who are long options. Some traders visualise the impact of time decay like Pac-Man, because it continuously eats away at the value of the option, particularly if the underlying stock trades sideways. This is where the Diagonal Bull Call Spread excels, because time decay is working for you.
Advantages & Disadvantages of the Diagonal Bull Call Spread
The primary advantage of a Diagonal Bull Call Spread is that it makes the mathematics of option trading work for you, because the Diagonal Bull Call Spread profits primarily from the difference in rate of premium time decay between the near-term short options and the longer-term option. This is possible as near-term option premiums decay faster than longer-term option premiums and this is most profound in the last few weeks of an option’s life. This strategy will profit if the underlying stock trades sideways or drifts modestly higher and/or lower before the short option expiry.
If the trade acts according to the initial trade plan, then the short option position expires worthless and you are then exposed to bullish movements in the underlying asset, which can be controlled at a discount for the longer term.
There are disadvantages in using this type of spread because profits will be limited, even if the underlying asset rises strongly. Losses can also be sustained if the short call options are assigned when the underlying asset rallies, but this risk can be eliminated by using European options which can only be exercised at expiry.
Additionally you do have the option to adjust your position during the time of the trade, by either closing out of the short options position, if you consider that either the underlying stock price is due for a bounce, or if you expect a strong rally to continue, or simply closing out the position.
Recent Trade – ANZ Bank (ANZ)
A recent trade that our clients took was to buy an ANZ Diagonal Bull Call Spread, two weeks prior to the October options expiry. ANZ Bank (ANZ) shares had pulled back nicely (5%) in early October, giving income traders an opportunity to take a position ahead of the upcoming dividend season. At that point, the stock was trading at a PE ratio of 14.5, yielding 4.9% fully franked.
The ANZ share price had fallen back from $31.80 down to $29.80 and was trying to establish support around this level. The $29.80 support level has held for the past few months and this was a trade for a bounce from these levels, on the expectation that the US lawmakers work come to an agreement before the spending authority expired on 17 October, which would have triggered a US debt default. While the chart looked oversold there was a chance ANZ would just trade sideways or modestly higher to around the $31.00 level, so the trade was entered into with a view to profit from a sideways and bullish move on ANZ while helping to reduce the risk.
To profit from this view we opened an ANZ Diagonal Bull Call Spread. The objective of this trade is for ANZ to ideally trade below the sold call strike at expiry. So instead of trying to profit from a sharp bounce from ANZ, we were looking to profit from a steady recovery of ANZ near-term. To put it more simply, we felt ANZ would hold around $31.00 before October options expiry (24 Oct’13) and trade higher from then on.
CHART 1: ANZ Bank – Diagonal Bull Call Spread entered on 10 October.
In this trade we entered the position on 10 October when ANZ was trading around $30.45, two weeks prior to expiry. The trade was established by Buying to Open ANZ 3050 NOV13 Call for 63c and simultaneously Selling to Open the ANZ 3100 OCT13 Call for 20c. The total cost was limited to the initial 43 cents premium paid.
The maximum possible profit on this trade would be achieved if ANZ held just below the short strike $31.00 level at October options expiry. The maximum risk on the trade was the initial debit; this would occur if ANZ is below $28.00 at October options expiry (or significantly below that level).
Payoff Diagram at Expiry October Expiry
CHART 2: Payoff Diagram at Expiry for the ANZ Diagonal Bull Call Spread 3050 NOV13/3100 OCT13 CALL Spread
As seen in the payoff diagram the trade will profit so long as the underlying stock price remains above $30.35. Note – if your view changed during the trade, you could buy back the short call or close the trade prior to expiry. Maximum risk is limited to the initial 43 cents premium paid, while maximum profit is 39c and occurs if ANZ finishes at $31.00 at October expiry.
Risks and Profit Potential
The Diagonal Bull Call Spread profits when the stock price trades sideways to modestly higher and finishes below the short strike price. The maximum risk is limited to the initial premium paid for the option spread. The maximum profit is also limited.
In summary the Diagonal Bull Call Spread strategy offers limited upside profit, while the maximum risk is limited to the Net Debit Paid. These risk/rewards are shown in the Payoff diagram above and as you can see the trade will profit so long as the underlying stock rises (or holds around current levels).
Note the Diagonal Bull Call Spread can be used in order to gain an exposure to ANZ Bank, while limiting the outlay and risk to the premium paid.
ANZ shares are currently trading modestly above the short $31.00 strike price and we were of the view that ANZ shares were likely to push higher for the end-of-month portfolio rebalancing. With ANZ trading around $31.65 the spread is currently worth 56c (or a profit of over 20%). Note that time decay is working for this trade so long as ANZ holds around the $31.00 level in the near-term.
Note transaction costs have not been included in these calculations.
Options can be used in order to gain leveraged exposure with limited risk, while still participating in potential profit movements in the underlying stock. In this article we’ve explained the Diagonal Bull Call strategy which can be used to allow you to participate if a stock is trading sideways or modestly up, while limiting your loss to the premium paid.
The market has provided some excellent opportunities this year. There are a number of dividend investment opportunities setting up right now that you could potentially profit from. If you would like more information please contact me at 1300 610 024 or email firstname.lastname@example.org.
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Investment Adviser – D2MX Advisor
Also In This Series
Part 1: The Protective Put
Part 2: The Covered Call
Part 3: The Covered Call Collar
Part 4: The Stock Repair Strategy
Part 5: Limited Risk Short Selling Strategy
Part 7: Dividend Capture Covered Call Collar
Part 8: Hedging With a Bear Put Spread
Part 9: The Bull Call Strategy
Part 10: Dividend Capture Covered Call Collar
Part 11: Calendar Call Strategy
Part 12: Bull Call Spread Strategy
Part 13: Reverse Calendar Call Strategy
Part 14: Short Selling Strategy with a Hedge
Part 15: Alternate Profit Taking Strategy
Part 16: Bullish on the Cheap
Part 17: Trade Smarter with Options
Part 18: Trade The Switch with Options
Part 19: Managing The Protected Capped Covered Call Collar Trade
Part 20: The Synthetic Long Stock Strategy
Part 21: Dividend Protection Strategy
Part 22: The Call Ratio Strategy
This report was prepared by Michael Hevern, Authorised Representative of D2MX Pty Ltd (AR 417348). It represents the views and opinions of the author. It is not intended for use by any third party, without the approval of Michael Hevern. While this report is based on information from sources which are considered reliable, its accuracy and completeness cannot be guaranteed. Any opinions expressed reflect my judgment at this date and are subject to change. Contracting Hevern Pty Ltd is a Corporate Authorised Representative No. 408868 of D2MX Pty Limited ABN 98 113 959 596, AFSL No. 297950 (D2MX), and Michael Hevern has been appointed as an Authorised Representative of Contracting Hevern Pty Ltd. Opinions, conclusions and other information expressed in this report are not given or endorsed by D2MX, unless otherwise indicated. The information contained in this Report is General Advice only, as the information or advice given does not take into account your particular objectives, financial situation or needs.
Disclaimer: Using leverage to invest can be a two edged sword, as it can magnify your returns when the stock price rises, but will in turn magnify the losses if the trade does not perform as expected.