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Welcome to our Options Trading Community

Hello out there and welcome to our new readers!  Our goal – above all else – is to create a community of successful options traders.

We regularly share our ideas about options trading and observations on market action, but this is a two-way conversation.  Please jump in, ask questions, contribute your ideas and discuss your successes – and failures.  There’s lots to learn from these shared experiences.

We’ll cover what we think is important to beginning options traders, but if there’s something you want reviewed, just ask us at info@olmsteadoptions.com.   Welcome!

- Dr. Olmstead and the Team

 
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UPDATED: Diagonal spread on Procter & Gamble with weekly options

Our previous entry on the diagonal spread trade pointed out how this strategy incorporates the best features of the vertical spread and the horizontal spread while avoiding some of the drawbacks of each.

In the previous entry and updates of that original article, the diagonal spread trade was illustrated with Procter & Gamble (PG) call options. It was also discussed how the trade could be continued forward by utilizing weekly options. The discussion here provides a final update and conclusion of the diagonal spread.

In early June with PG trading near $78, it was anticipated that the stock price might be moving up over the next six weeks in anticipation of a strong earning report on August 1. To guard against some time loss in a long call option while waiting for the stock to move up, a diagonal spread with PG call options was selected.

Original Trade (6/11): Buy 1 July (monthly) 75 call for $3.60 and sell 1 June (monthly) 80 call for $.35 for a net cost of $3.25.

First Continuation (6/21): With PG trading around $77.50, the June (monthly) 80 call expired worthless. The June (weekly exp 6/28) 80 call was sold for $.15, reducing the cost basis of the July (monthly) 75 call down to $3.10.

Second Continuation (6/28): With PG trading around $77, the June (weekly exp 6/28) 80 call expired worthless. The July (weekly exp 7/5) 80 call was sold for $.10, reducing the cost basis of the July (monthly) 75 call down to $3.00.

Third Continuation (7/5): With PG trading around $78.50, the July (weekly exp 7/5) 80 call expired worthless. The July (weekly exp 7/12) 80 call was sold for $.25, reducing the cost basis of the July (monthly) 75 call down to $2.75.

Conclusion (7/12): During the week of July 8-12, there was a 4.1% surge in the price of PG stock which closed at $81.55 on Friday (7/12). With the July (weekly exp 7/12) 80 call in-the-money by $1.55, it was time to close the diagonal spread. Even though the long option in the diagonal spread still had another week before it expired, it was best to view the diagonal as a vertical spread that had achieved its maximum possible return. Under these circumstances, the only sensible action was to exit the trade.

Near the close of trading on July 12, the diagonal spread could be closed for a net of $5.30. This included an extra $.30 of time value in the long call that still had another week before expiration. Using the cost basis of $2.75 going into the last week of the trade, the profit of $2.55 represented a yield of 93%.

This PG trade was a good illustration of how the diagonal spread can utilize the best features of the horizontal and vertical spread strategies. Like a horizontal spread, it repeatedly captured premium from selling weekly options. Then when the stock price moved so that both legs were in-the-money, the diagonal spread functioned like a vertical spread that had achieved its maximum profit.

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Diagonal Option Spread on Procter & Gamble (PG) – Continuation with Weekly Options

Our previous blog entry on the diagonal spread trade pointed out how this strategy incorporates the best features of the vertical spread and the horizontal spread while avoiding some of the drawbacks of each.

In the previous entry, the diagonal spread trade was illustrated with Procter & Gamble (PG) call options. It was also discussed how the trade could be continued forward by utilizing weekly options. The discussion here provides an update on the original diagonal spread and indicates how it could be continued forward toward the July 19 expiration date.

In early June with PG trading near $78, it was anticipated that the stock price might be moving up over the next six weeks in anticipation of a strong earning report on August 1. To guard against some time loss in a long call option while waiting for the stock to move up, a diagonal spread with PG call options was selected.

Original Trade (6/11):

Buy 1 July (monthly) 75 call for $3.60 and sell 1 June (monthly) 80 call for $.35 for a net cost of $3.25.

First Continuation (6/21):

With PG trading around $77.50, the June (monthly) 80 call expired worthless. The June (weekly exp 6/28) 80 call was sold for $.15, reducing the cost basis of the July (monthly) 75 call down to $3.10.

Second Continuation (6/28):

With PG trading around $77, the June (weekly exp 6/28) 80 call expired worthless. The July (weekly exp 7/5) 80 call was sold for $.10, reducing the cost basis of the July (monthly) 75 call down to $3.00.

Third Continuation (7/5):

With PG trading around $78.50, the July (weekly exp 7/5) 80 call will expired worthless. The July (weekly exp 7/12) 80 call was sold for $.25, reducing the cost basis of the July (monthly) 75 call down to $2.75.

Outlook (7/5 to 7/19):

By selling weekly calls every Friday beginning with 6/21, the original cost of the July (monthly) call has been reduced from $3.60 down to $2.75 while waiting for the price of PG stock to move up. This continuation with weekly options has produced a profit when simply holding the long Jul 75 would currently reflect a small loss. Moreover, it has not been necessary to abandon the original viewpoint that PG stock would make a move up as we progress toward the expiration our July 75 call on 7/19.

By continuing the diagonal spread with the selling of weekly options, sufficient compensation has been achieved to offset the time value lost in the long July (monthly) call. If at any time along the way, there had been a surge in the PG stock price to a level above $80, the diagonal spread could have been closed for a nice profit. Selling weekly options also allowed for a frequent re-evaluation of the long position to see if an early exit seemed appropriate.

 
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Ilustration of the diagonal spread using Procter & Gamble (PG)

In a June blog entry, we discussed the virtues of the diagonal spread.  To more clearly illustrate the diagonal trade, let’s consider a current trade on a popular Dow stock, Procter & Gamble Co (PG).

Example Trade: In early June, PG was trading at $78 after a modest pullback. With an earnings report due on August 1, it was felt that PG would likely be moving up over the next six weeks.

Trade: One July (monthly) 75 call was purchased for $3.60 and one June (monthly) 80 call was sold for $.35. Net cost of the trade was $3.25.

Comment: Note that the premium received from the sale of June 80 call reduced the cost basis by about 10%, which is significantly less that what would be expected in a vertical or horizontal spread. The diagonal spread is typically more expensive than a vertical or horizontal spread, but that is offset by the potential to benefit from a quick directional move.

Trade Evaluation: On the expiration date of the June (Monthly) 80 call, the trade will be at break-even or better if PG is above $77.50, and will show a profit of at least 40% if PG is above $79. If PG is at $80 or higher, the trade will have a profit of about 60%.

Comment: At the June expiration date with the stock at $80, the July (monthly)75 call by itself would show a profit of only 46%.

Trade Continuation: If PG has not reached $80 when the June expiration date arrives, the June (monthly) 80 call will expire worthless and the July (monthly) 75 call will have a reduced cost basis of $3.25. This option can then be held for unlimited future gains.

Since PG has weekly options, there is an opportunity to continue this trade on a week-by-week basis as you wait for the PG stock price to move up. The premium received from the sale of a weekly call can help offset the time decay in the long option until PG makes its move.

Trade Continuation with weekly options: If PG is below $80 at the June (monthly) expiration date, the June weekly 80 call might be sold for $.25. This will reduce the cost basis of the July (monthly) 75 call to $3.00 while still allowing for plenty of upside potential for a profit.

 

 
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Market volatility and the VIX

Yesterday’s market volatility was reflected in the price of the VIX, which rose to a year-to-date high of 21.32 shortly before the close of trading. This indicator is based upon the implied volatility of S&P options, and it is frequently viewed as an indicator of market movement in the near future. Back in February and again in April, the VIX displayed sharp upward bursts in response to a market selloff, but then quickly pulled back as the market resumed its uptrend. We will be following the VIX closely to gain insight into near term market behavior.

 
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Acquiring stock by selling puts – a sound strategy?

A frequently mentioned strategy for acquiring shares of a desirable stock is that of selling naked puts and waiting to have the stock assigned. Advocates of this strategy argue that this is a great way to buy a stock at a discount price. While there is some potential value to this strategy, it is unclear that this approach is always a sound way to acquire a stock.

Let’s look at a case that was recently profiled in the financial press to investigate the pros and cons of acquiring stock by selling naked puts.

Astex Pharmaceuticals Inc (ASTX) is a popular stock with a price that has been in a steep decline since the beginning of May. Recently the stock price appears to have bottomed out near $4.50 per share.

On June 11, with ASTX stock trading at $4.60 per share, a single order to sell 5,000 contracts of the Jul 4.5 puts was filled at $.32 per share. There was no evidence that this was part of a spread order that would have hedged the short puts. Ostensibly, this order was placed by a put seller (firm or individual) that has some potential interest in owning 500,000 shares of ASTX stock.

Positive side of this strategy

The arguments in favor of this trade point out that if the stock price is above $4.50 at the July expiration date, the short naked puts will expire worthless and the seller keeps the $.32 per share. On the other hand, if the stock price is below $4.50, the seller will be assigned the stock and thereby acquire 500,000 shares at the discounted price $4.18 per share [4.50 - .32 = 4.18]. An important point about this stock acquisition strategy is that while the put seller does not need to have all of the cash available to purchase the stock prior to the options expiration date, there will still be a substantial margin requirement imposed as soon as the puts are sold.

Negative side of this strategy

To see the negative side of this strategy of selling naked puts, suppose that ASTX stock has bottomed out near $4.50 a share and rises to $5.00 or higher by the July options expiration date. The put seller may regret not having decided to buy 500,000 shares of stock at $4.60 per share while simultaneously selling the Jul 5 calls for $.35 per share. That combination represents a discounted stock price of $4.25 per share [4.60 - .35 = 4.25], and if the stock price is above $5.0 at the July options expiration, the stock will be called away for a total profit of $.75 per share [.35 + (5.00 - 4.60) = .75]. On the other hand, if the stock price begins to fall, it may be possible to roll the short Jul 5 calls down to the Jul 4.5 calls so as to receive a total of say $.45 from the two short call transactions, thereby reducing the cost basis of the ASTX stock down to $4.15 per share [4.60 - .45 = 4.15].

Conclusion

The primary point of this discussion is if you are bullish on a stock that is near a bottom in price, you may be better off buying the stock than going through the acquisition process of selling naked puts. If you are correct in your assessment that the stock is ready to start moving up, you are likely to achieve a better return by simply buying the stock and selling out-of-the-money calls. Even if the stock continues to fall a bit lower, your cost basis for stock ownership may be about the same as that of the put selling strategy.

 

 
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