Understanding the Hidden Risk of Time Diagonal Spreads By Jeff Look July 16, 2008

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1 Understanding the Hidden Risk of Time Diagonal Spreads By Jeff Look July 16, 2008 Quick Summation To avoid the hidden risk of a time diagonal spread, remember to always apply the following rule when picking the strike price of the option you sell: Long Option Strike Price + Long Option Debit < Short Option Strike Price The strike price of the option you sell MUST BE HIGHER than the total of the strike price of the option you purchase plus the cost basis of your long option. Note: after a successful first trade, your cost basis in the long option will have been reduced. Consequently, adjust your cost basis accordingly in your formula for calculating the short strike for successive months. Introduction A time diagonal spread may be created with either calls or puts, depending on your market direction forecast. For this example, we will assume we are bullish and will concentrate on using calls. A call time diagonal spread is created by buying to open a call 2 with 2 or more months of time remaining, and selling a higher strike call with less time remaining (usually a front month option to take advantage of the quick time decay). For example, IBM is trading at $ in late July, You anticipate the stock will appreciate to $130, but that it will take several months. Instead of buying a call and allowing time decay to work against you while waiting for the stock to make its ascent, you might consider a time diagonal spread by buying the October $120 call for $9.10 and selling the August 130 call for $1.70, resulting in a net debit trade for $7.40. At time passes, you anticipate having the opportunity to sell the September 130 call, creating a second time diagonal spread and bringing in further credit. Eventually, you plan to sell the October 130 call creating a bull call spread. A time diagonal spread is a moderately bullish strategy you forecast the stock to make a modest or slow move over an extended period of time. In this vein, the time diagonal spread is related to both the covered call and the bull call spread. By comparing the P/L charts of these three strategies in our IBM example, you discover the hidden risk of improper implementation of the time diagonal spread. A covered call, buying the stock and selling the August 130 call would have created the following P/L at August expiration:

2 For purposes of this discussion, the actual profit or loss resulting from the trade is not the issue. Look at the picture the trade represents. Profit is capped to the upside, yet there remains unlimited loss potential (to $0.00) to the downside. Due to this unlimited loss potential, traders wishing to limit their downside risk may turn to the bull call spread, simply replacing the stock with a long call of the month as the call sold. As the P/L chart of the 120/130 bull call spread demonstrates, risk to the downside is now limited, while maintaining the capped profit potential to the upside. The benefit of having limited risk to the downside in the bull call spread does not come without a cost the stock MUST appreciate before expiration to cover the cost of the debit of the trade, whereas, in a covered call, the stock can remain stagnant, or fall slightly, and the trade can still show a profit. The time diagonal spread is essentially a bull call spread with added time on the long option. Consequently, at first thought, one would anticipate that the P/L chart of a call time diagonal spread to be very similar to a bull call spread namely, capped maximum potential to the upside, and a limited, but larger loss to the downside as a result of the higher debit paid for the added time. However, as the picture demonstrates, this is not quite as expected.

3 Downside loss is limited, and higher than in the bull call spread due to the added debit paid. The upside is capped and maximized at the short strike price, just as was the case in both the covered call and bull call spread. Note however, the loss of some of the trade s profit if the stock moves beyond the short strike price. This loss is a result of the nature of the trade. On expiration, if the short strike is in the money, it will be executed. The trader will be faced with two choices, buy stock at the current (higher) market price to deliver on his obligation, or executing his own call to purchase stock at the reduced strike price, but forfeiting the time premium left in the long call. Either action results in a loss, which reduces his profit on his long call. Consequently, the P/L chart shows a diminished maximum profit as the stock moves beyond the short strike price. The Hidden Risk This hidden risk of loss of profit is at least bearable, since the trader is exiting the trade with a profit. However, it assumes the trade was entered using appropriate strikes. Failure to use appropriate strikes for the long and short calls can turn a potentially profitable trade into a losing trade, even if the stock moves in the direction the trader forecasted. The trader must be aware of and chose strikes for the trade using the following formula: Long Option Strike Price + Long Option Debit < Short Option Strike Price The strike price of the option sold MUST BE HIGHER than the total of the strike price of the option purchased plus the cost basis of the option purchased. In our example, the strikes were chosen properly. The diagonal spread was created by buying the October $120 call for $9.10 and selling the August 130 call for $1.70, resulting in a net debit trade for $7.40. $120 + $7.40 < $130

4 The total on the left side of the equation, $127.40, is indeed less than the right side, $130, and guarantees the trader to return a profit regardless how high the stock rises before expiration. As a comparison, look at what happens if the formula is not followed. Assume, for example, that the trader decides to sell the closer to the money Aug 125 strike for $3.90 to bring in more premium. The trade now results in a smaller debit of $5.80. However, now the formula is incorrect: $120 + $5.80 < $125 The total on the left side of the equation, $125.80, is NOT less than the right side, $125. Consequently, the trader is now in a situation where, if the stock price rises quicker than anticipated, the trader can actually LOSE money on the trade, not just lose some or all of the accumulated profit. Obviously, this P/L chart is not analogous to the covered call or bull call spread P/L charts previously shown. Changing the short strike price from $130 to $125 in the covered call or bull call spread examples does NOT change their basic picture as is the case with the time diagonal spread:

5 Covered call using $125 strike Bull call spread using short $125 strike Conclusion Always use the stated formula when choosing the short strike price in a time diagonal spread.

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