Options Trading: Do Diagonals Beat Covered Calls?
By: Steve Smith
The covered call strategy is one the most popular options trading strategies, especially among investors that don’t consider themselves option traders.
It’s a way for owners, especially for buy and hold types, to generate income from the stocks they own while also providing a bit of a hedge for their portfolio.
But for those that might not want or don’t have the funds to own a lot of shares in many different names there is an all options trading strategy that replicates a covered call but is much more capital efficient and therefore can deliver much higher rates of return.
It is called a diagonal spread, and A.J Brown takes one of the deepest dives on the topics in this article.
In my observations over the last 15 years of being a trainer of stock and option traders, I have found many folks, both novice and experienced, who write covered calls, but do not truly understand them. It’s no wonder when I introduce a variant, like the diagonal spread, that eyes gloss over as the theory and practice I explain, falls on deaf ears. Often at the end of a conversation I’ll hear, “that’s something I’m going to have to grow into,” or “the math in that is over my head right now.”
We embrace diagonal spreads as a lucrative variant of writing covered calls.
The goal here is to not only clarify covered call theory and practice, but to also explain a variant, diagonal spreads, in a way that can be consumed.
When a trader writes a covered call, usually they are looking to sell theta decay, a component of premium. They often will not consciously understand that, but when quizzed, that is generally their objective. Selling premium can mean many things, but in this writing we mean selling extrinsic value.
Extrinsic value is the component of an option price most influenced by time passing by, the underlying symbol price changes, and the buying and selling pressures of the option itself. Intrinsic value, the other component of an option price, is that actual value of the option at expiration; the real tangible value. The intrinsic value is only a function of the underlying symbol price and the option type (call or put). The intrinsic value of an at-the-money or out-of-the-money option is zero.
Near term premium is what is most often sold. Here is a graph showing how the value of premium is not linear with time. An option will lose much less value over a day passing, when it is 60 days from expiring than when it is five days. The risk with covered call writing is that the underlying symbol will appreciate, causing the buyer of the option to exercise it, or worse, depreciate, leaving the seller with a premium against a devalued underlying symbol. Selling near term premium optimizes the highest selling price with the least amount of time to wait for that price to decay. Our intention is to buy our call option back at a much lower price or let it expire worthless.
Successful covered call writers know to look for underlying symbols that trade sideways in clear horizontal channels. Researching the underlying symbols is paramount. I often describe to my students that an intimacy needs to be formed with the underlying symbol such that you have confidence in its reaction to stimulus.
The intention is to sell multiple cycles of premium against the underlying symbol. One reason is the amount of research and familiarity that goes into picking an underlying symbol is long and arduous. It is not something a trader wants to spend their time doing often. Once you find an underlying symbol to write premium against, you would like to stick with it for a while. Another reason is simply the calculation of return on invested capital.
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Every cycle you sell premium against an underlying, and it expires worthless, lowers your investment. The profit of the previous cycle is subtracted from your investment. The profit of the current cycle over the lowered investment, exponentially increases your return on invested capital. Each subsequent cycle, you have profit on a lowered investment. It is not linear. Let that sit for a moment.
I sell monthly premium. There’s ample liquidity in the monthly options. On average, I am in a covered call for four to five months, four to five cycles. My record is 14 months, 14 cycles. On that trade, my initial investment was reduced to zero.
Successful covered call writers look to sell premium at strike prices that are just out-of-the-money from resistance of their underlying symbol’s horizontal channel, to have the least probability of being exercised. They will pay close attention to whether their underlying symbol issues dividends. Many buyers of options will factor in dividends and will often exercise an out-of-the-money call option if the expected dividend makes the economics work for them.
Our investment price, also referred to as cost basis or, even more descriptive, break-even price, is the difference of our initial investment in the underlying symbol and the premiums we collect over time. Our profit zone is therefore between our cost basis and our sold call option’s strike price.
The Diagonal Spread Variant
A way to increase the return on invested capital potential of a trade is to reduce the initial investment. Recall that an option price is the sum of its intrinsic and extrinsic value. Recall that the extrinsic value is greatest when the option is at-the-money and then tapers to zero on either side.
To create an underlying symbol replacement, we can use deep in-the-money call options. The ideal would be to have call options trading at parity. A call option trading at parity has zero extrinsic value, and therefore trades dollar-for-dollar with its underlying symbol. In a hypothetical example, if an underlying symbol increases from $100 to $102, an ideal deep in-the-money call option, trading at parity, would increase from $30 to $32.
Recall that it is probable that this trade could last four to five cycles and, in the extreme case, may last 14 cycles or more. We use far out-in-time options for this reason. The ideal would be to have a call option expiring at a date later than 14 cycles. If available, we purchase LEAPS a couple of years out.
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Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.
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