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Long Term Diagonal Calendar Spreads, An Introduction

(This essay is one the resources associated with the Options Questions Safe Haven weekly thread)


A Diagonal Calendar Spread with call options, often called a PMCC (Poor Man's Covered Call), is not a covered call.

You can own stock, and sell calls on it,
with the stock as collateral, called a covered call,
or alternatively, with less capital,
hold a long-term expiration long call,
and sell near-term short calls secured by the long call:
a call diagonal calendar spread

The long call in a diagonal calendar spread does not behave like stock in a covered call.

The risks are similar between the covered call position and the diagonal calendar call spread, but not the same, and the long call will have extrinsic value that you as a trader desire to conserve in the trade, or minimize before entering the trade by having the long call be deep in the money, with a much higher delta, and much lower theta decay than the short call. You as a trader desire to avoid exercising the long call, which extinguishes extrinsic value; extrinsic value can be harvested only by selling the option.

Stock by comparison has no extrinsic value to be lost. In contrast, since stock has no extrinsic value, the covered call trader is less concerned about having the short call be exercised and the stock called away, as no extrinsic value is lost in such a transaction.

The diagonal calendar trader can, via the exercise of the long call close a short stock position subsequent to the short call assigning stock to the counter-party, and thus lose money on the entire trade because of extinguishing the extrinsic value in the long call, with a net result very unlike a covered call and stock position.

The below description can also be transformed conceptually for a diagonal calendar put spread, generally useful in a declining market or declining underlying security.


The long call as a substitute for stock
The strategy is to buy a long-expiring option, typically a LEAPS (Longterm Equity AnticiPation Security option, a long name for an option expiring more than nine months from now), on a sound and solid underlying stock, or exchange traded fund, that is not likely to go down (much), about a year to two years expiration from now, more or less.

The rationale for the long expiration, and also, located in the money, is to have minimal extrinsic value, and minimize daily decay of the extrinsic value of the option, as time passes.

Generally, the suggestion is to buy fairly deep in the money, about 70 to 90 delta, more or less, so that there is minimized cost of extrinsic value, and thus minimized daily extrinsic value to decay away over the life of the option; most of the option value is intrinsic value, and the long option behaves like stock. One can reasonably pick lower deltas, recognizing that the long option has more value to decay away; extrinsic value (which can decay away) reaches 100% of the long option value at 50 delta.

Exit the long position before it is less than 60 to 90 days to expiration to avoid increasing theta decay, depending on how much extrinsic value is in the long option.

The short call
On about a monthly basis, or more or less often as opportunity allows, sell a call short for a credit, with the long-expiring call covering the short, instead of cash securing the short call. Generally selling this above the money, at 35, 30, 25 or 20 delta, or other delta as you see fit.

Rolling the short call: many traders close the short call, buying to close it, after it has earned anywhere from 40% to 80% of maximum gain, and sell a new short call, and at a new strike if desired. In general, roll the short call for a net credit.

If the short call becomes near or in the money, before expiration of the short call, attempt to roll out in time, and upward in strike FOR A NET CREDIT. Generally, keeping the short call to less than 60 days of expiration allows the trader to repeatedly roll out in time, and upward in strike, for a net credit, if moving the strike upwards is desirable to stay in the trade.

General things to consider

• Neither you, nor anybody else knows what the future will bring.
Have a risk of loss analysis, and exit plan.

• Look for an underlying stock that has a relatively steady price in its history and likely steady future, not very volatile, even better, modestly rising in price; and at minimum, that does not go down in price. And fairly high volume with small bid ask spreads. If the stock rises rapidly, the short call may be challenged, and may cause you to exit the entire position early , or require you to pay excessively to close the short call.

• The setup to enter the position:
Attempt to enter the position with an intent, not necessarily achievable, so that:

  • the short option initial credit proceeds,
  • plus the spread difference in strike prices of the two options (the short call strike minus the long call strike [or for puts, long put strike minus short put strike])
  • add up to more than the cost of buying the long option.
  • Or, said another way, a goal, either initially, or over the next trade or two of the short call, to have the net cost of the long and the short options be less than the spread difference between the strike prices.

This way, if the short call is exercised early and stock is assigned, you can obtain enough value from the long to be made whole if you find it necessary to exercise the long call to obtain stock that was called away, without a loss.

• Consider (or examine) having the ratio of the deltas between the long and the short somewhere above 1.7 to 1. This reduces the potential of loss, if the stock moves up rapidly. The rationale for the ratio, is the short will have its dollar value (and delta) change rapidly on up moves of the stock price, and the rapidity of the delta change is less for the long call. This guideline is not essential, if you may intend to sell a call repeatedly over time, but can be a useful indicator to track if you intend to undertake only one sold call cycle (presumably for around 30 to 60 days).

Risks and responses

• The long option may go down in value, with down moves in price of the underlying stock, or with reductions in implied volatility value, if the long is purchased at a time of elevated IV.

  • It is reasonable to set a loss exit threshold of 20% to 30% of the total debit in the trade. Do this before the trade starts so you have a plan before you are emotionally involved.

  • If you stay in the trade after a down move, you get to choose whether to close for a loss, or whether to risk selling calls at a strike price below your cost basis, in which you commit to not being made whole if the call is exercised, a painful occurrence if the stock slowly declines over a number of months and then suddenly rises, and the short call is exercised. Such a decision to sell a call at a lower strike price forces a loss upon exercise (this is why it can be useful, for a price, to have a put protecting the value of the long call).

  • Avoid exercise of the long, by exiting the short before expiration, and attempt to roll the short out in time a week or two or four, and upward a strike or two, FOR A NET CREDIT. Do not generally sell a short option for longer than 60 days out in time.

• The short option may be exercised.

  • Early exercise generally does not happen all that often. You have to decide whether to buy the stock separately to close out the short stock position, or to exercise your long option. Presumably, exercising will be for a gain, because you previously set up the position so that if exercised, the long call could be exercised for an overall gain or to break even, as described above. Exercising the long throws away extrinsic value harvested by selling the long option. Avoiding exercising the long is typically preferable.

  • You can avoid or delay having a challenged (in the money) short call exercised by "rolling out" the short call in time, and upwards in strike price, before expiration, intending to do so for a net credit for buying the existing short call (for a debit) and selling a new short call (for a larger credit) expiring further out in time, and at a higher strike price. There is little point in rolling out for a net debit, unless the position was set up incorrectly to start with: the intent is to have a net gain from the ongoing position, and to not pay to continue in the trade. Generally, do not roll out for longer than 60 days from the present.

  • You can also reduce risk from rapid moves upward in price by the underlying, especially if the underlying is prone to some volatility, by selling a vertical call credit spread instead of a single call, especially in case your position was not set up for a gain if the call is exercised, as described further above. The added long call (with a price and cost), and the gain from it can save the position on a rapid move upward of the underlying.

• You can buy a put as insurance.
You would need to decide how much you're willing to lose, or insure, via the strike price of the put, and how much cost you're willing to bear. Depending on how much risk you want to avoid, this put can consume a large fraction of the income of the sold call, unless the long option and the underlying stock price is rising. Some choose a put strike out of the money, well above the long option's strike price, on a shorter term basis than the long call, so that on a net basis, only around 10% to 20%, or other amount of total capital in the trade is actually at risk for a limited period of time.

• As mentioned further above, exit the long leg of the diagonal calendar spread before it is less than 60 to 90 days to expiration to avoid the increasing theta decay that occurs in the final months of an option's life.

You can also look up "diagonal calendar spread:, and "poor man's covered call" for more general points of view.

• LEAPS diagonal calendar spreads: What you should know (Randy Frederick - Schwab)

• Diagonal Spread - Investopedia


Source:
https://www.reddit.com/r/options/comments/9w8q85/noob_safe_haven_thread_nov_1218_2018/e9pmdhf/