Diagonal Spreads - Why Gamble on Stocks, When You Can Be the House?

Don Shapray

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by Don Shapray

Stock speculators are always looking for an edge before making an investment. Their pick is based upon extensive research which includes many factors, such as the stock's past history and movement, expected earnings reports of the stock's parent company, volatility and volume of shares traded daily, and any current news concerning the company's growth or profitability. Yet when it is all said and done, the speculator’s selection still boils down to calculated risk. In essence, it is a wager, much as you would place in a Las Vegas casino. Of course, why do you think they’re called speculators in the first place?

That is not to say that there isn’t any inherent risk associated with stock option trading. Far from it. However, like a wily card counter at the blackjack table, a knowledgeable stock option trader can limit their risk, hedge their bets and employ other people’s money in the pursuit of profit.

For instance, when you purchase a Call option:

1. You expect the price of the underlying stock to rise, so you can then purchase it at the lower strike price, making a profit in the transaction.

2. You have the right to control 100 shares of stock for a fraction of the cost of purchasing the stock outright.

3. You are managing your risk by limiting the downside to the premium paid for the option. The major downside to buying any option is time decay. Your option expires within a finite period of time. If the underlying stock price behaves as expected, you will not need to be concerned about execution.

Having shown you the benefits of buying Calls over the risks of purchasing the stocks outright, we must emphasize the fact that buying short-term Calls has its associated risks as well. A Call buyer, especially a short-term Call buyer, is severely limited by the time-decay factor. The nearer to the expiration of an option, the less the option is worth, and the less time is remaining for the option to become profitable. Within the leverage used by gambling casinos (the house), the concept of short-term Call buying is completely understood, as well as exploited, as gamblers are considered short-term Call buyers.

However, what if you could use several of these factors in combination to your advantage? This is what diagonal spreads are all about. Using diagonal put spreads, you would buy a long term Put for a selected stock, while simultaneously selling a short term Put for the same stock.

Consider your long-term Put, or Call, as a 6 to 8 month license to operate a casino. It allows you to capture short-term premiums; money that gamblers continuously give to you in attempting to beat the odds by speculating they will make profits on very risky bets. They feverishly feed the slot machines, ante up at poker, double-down on blackjack, or spin the roulette wheel. The odds are overwhelmingly against these short-term buyers. You, as the casino owner, continuously capture these short-term premiums, easily offsetting the expense of the license to operate the casino, then earning substantial, clear profits in the following months. They know the odds are with the casino owner, but they still take the enormous gamble on the slim chance they will hit a jackpot. The lottery works in the same manner.

On one side of the position, the transaction is definitely gambling, while on the other, the casino is simply transacting business. Would you rather bet on the remote chance of a gambler's rare, limited success, or rake in the steady, routine premiums captured from operating a successful business?

Yes, occasionally a gambler does beat the odds to enjoy a limited, windfall return on his or her bet. For the casino owner, that is simply part of the cost of doing business. But we all know where the true, long-term profits lie. 30%, 40%, 50% and more, are common, and in short periods of time. The odds are with the short-term option seller, not the buyer.

When you choose a stock for short-term Call buying, you not only must carefully consider the proper stock for the type of option you are purchasing, you must also decide which direction the stock will move, then, that movement must occur within a specified, very limited period of time. Many investors have gone broke by attempting to make those same decisions. In short, time is not on the side of the short-term option buyer. It is on the side of the option seller.


Buying stocks is risky.

Buying short-term options is less risky, but still risky.

Selling short-term options is the least risky, especially with a hedge, or insurance.

When you sell a Call option:

You expect the underlying stock price to fall, so the option will not be exercised, but expire, worthless. You can then capture the entire premium that was paid to you, as profit. If the underlying stock price rises, you are obligated to sell 100 shares of stock at the lower strike price. If you do not already own those shares, you would then have to buy them at a higher market value, then sell them at the strike price, in order to meet your obligation. This situation is called a “Naked, " or “Uncovered" position, and is extremely dangerous. Anytime you sell a Call option you should consider buying the same option with a slightly lower strike price, and longer expiration date. This will reduce your profit potential, but will also reduce your risk considerably. (Remember the parallel twins, Risk and Reward - If you want to reduce risk, you must also give up some degree of potential rewards. You may wish to lower your cost basis in the stock, to the extent of the premium received.

When you purchase a Put option

1. You expect the price of the underlying stock to fall, allowing you to sell stock at the higher strike price, and thereby earning a profit.

2. This option is also used in a combination strategy as a hedge against selling Puts. We will explore that strategy later, in detail.

3. Buying Put options could also be used as a hedge, or insurance, against the possibility of a price drop in stock you already own. Consider the following:

You own 100 shares of ABC stock, and are concerned that the stock price could suddenly fall. You purchase a Put option on the same stock, with a strike price at current market value. If your stock falls in price, you would have the right to exercise your option and sell 100 shares of ABC stock at the higher strike price. The premium you paid for the option could be far less than the loss you would have incurred without that insurance. In this instance buying Puts acted as a hedge against the possibility of a price decrease in the stocks you already own. If the price of the underlying stock increases, your loss is limited to the premium you paid for the option. The option acts as an insurance policy against possible loss.

Selling a Put option without an opposing hedge -"Naked"

You expect the price of the underlying stock to increase, causing the Put option you sold to expire worthless. You can then capture the entire premium paid to you, as profit. If the underlying stock price were to fall below the strike price, then you would be obligated to purchase the stock at the strike price, or pay the difference between the strike price and the stock price, if you do not want to own the stock. Your upside is limited to the premium received for selling the option. Your downside is potentially unlimited to the base value of whatever you could sell the stock for on the open market, or to the difference between the strike price and the stock price. This is a “Naked, " or “Uncovered" position, and should never be allowed to occur, unintentionally. Without the implementation of combination strategies, the main objective of the Put seller is to hope the option expires, allowing him to capture the entire option premium as profit.

Nearing expiration, if the stock price moves below the strike price, changing the option's value to ITM, and highly vulnerable to exercise, then the option seller must move quickly to buy back the option, perhaps lessening his profit potential, while also managing his risk. Even so, a small loss would be better than having to buy 100 shares of stock at inflated prices. Also, the loss can be immediately compensated for by simultaneously selling another Put expiring in the following month. We use OPM (Other People's Money) to buffer downside risks, while buying more time for the stock price to rise.

Just as in the gaming halls of Las Vegas, while a gambler’s fortune may rise or fall, in the end the house always wins. So I ask you, why gamble on stocks when you can employ diagonal spreads to be the house?

Donald Shapray, investment strategist and former National Options Manager for Charles Schwab & Co. , has coached investor audiences on the Stock Market Channel on television and on business talk radio. For more information, and Free Stock Options Trading Audio Book, go to http://www.ascentoptions.com for Better Stock Option Trading.


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