Beginner's Guide to Trading Long Call Diagonal Spreads | Selecting an Option Strategy
[Music] foreign [Music] good morning and welcome everyone my name is Cameron May it's 9 30 Eastern Standard Time on a Thursday morning the opening bell has just sounded and that means that it's time to get back to our ongoing weekly series of discussions called selecting an option strategy and today I thought with the dozens and dozens and dozen potential potential option strategies that one might select I know what market conditions might one choose to do a diagonal spread today is going to be sort of a beginner's guide to Long call diagonal spreads I'm looking forward to that discussion we'll set a more precise agenda for it in just a moment let me first of all say hello to everybody checking in from all around the country I always like keeping my eye on chats before we kick this off I like to see all those familiar names out there in YouTube hello there Andrew Vijay David uh Michelle Mansour Larry Michael um let's see who else is here Dom Tony boss Chris B VJ Ray Juanita Brenda Hartman Paul on and on that list goes fayez thanks everyone for joining me week after week I definitely appreciate your attendance your contributions to these discussions if you're here for the very first time I want to welcome you as well if you'd like to chat in let me know this is your first time in one of my webcasts always I do like to see who's here uh and as a first timer and if you're watching on the YouTube archive after the fact enjoy the presentation but be aware that you're invited to join us in the live discussion kicks off just as I mentioned right at opening bell Thursday mornings and this one runs about 30 minutes now um a final note here is that if you actually let me just make a quick note here we're joined by my very good friend uh Pat malali he's going to be helping out in chat so if you do have questions ask those questions I'll try to address them if I can't Pat will uh as long as they're on topic all right now let's uh let's get into it very first thing that we always do is pause to consider the risks associated with our investing in as I do that I want to give you a quick invitation to follow Pat add me on Twitter if you're not following Pat his Twitter handle at P malali underscore TDA malali is m-u-l-l-a-l-y my Twitter handle is at C May underscore TDA and and that's where you will find us if you're looking for us in between our webcasts we're very commonly on Twitter and if you reply to me I try to reply right back to you all right now we also need to bear in mind the risks associated with investing this is important information the content we're about to provide is intended for educational or informational purposes only options are not suitable for all investors there's a special risk inherent options trading May expose investors to potentially rapid and substantial losses any investment decision you make in your self-directed account is solely your responsibility having success with your paper money account is not a guarantee that you can have success with your real funds as market conditions do change and they can change rapidly while this webcast discusses technical analysis other approaches including fundamental analysis May assert very different views and finally all investing involves risks including the risks of loss all right so let's set the agenda for the day as I mentioned we're going to be talking about long call diagonals so when might a Trader choose a long call diagonal as the appropriate strategy for their current market condition convictions well we're going to ask ourselves three questions about current conditions this is going to set the stage we're going to look at the markets in pursuit of the answers to those to those questions and then we're going to get to that paper money strategy so first of all a discussion of the conditions setting the stage for the example strategy and then we'll get to the strategy and even place a trade all right so that's the agenda for the day let's go right to think or swim right over here is a reminder of the three questions that we ask ourselves each week so if you haven't ever been in one of my webcasts before go through sort of a process of elimination we start with dozens of potential option strategies and we ask ourselves well if we're going to pick one of these do we want a bullish strategy a bearish strategy or neutral strategy is it going to be built around buying or selling and are we are we looking for high probability of uh of success or a high reward Potential from that strategy so those are our three questions right there so let's go through these and see how they might fit a long call diagonal spread so first of all let's look at market conditions what do we think if we're planning a new trade should that trade be bullish bearish or neutral let's pop over here to our charts here's the S P 500 and you're saying you can't hear me others are saying that the the sound is good my suspicion is my apologies to Andrew we might have to watch this on the archive or just draw refresh yeah BJ that's a good suggestion if you ever find yourselves can't hear the audio or something else is going on but you're not seeing a lot of other complaints because I have about 140 people watching now that might be an indication there's something from your end if there if there's something that's affecting everybody like if the sound had gone out completely that that chat window would be lighting up with everybody letting me know that the sound isn't working right yeah so thank you Eddie that's perfect yeah so anybody else if you want to chat in and say like Robert has and Eddie has and who else uh Chris B make reference to sound that just lets Andrew know or let someone else know who can't hear that they probably have something to deal with on their end okay but let's look at the S P 500 let's try to determine if we're planning a new trade would a Trader maybe lean toward bullish or bearish and what we've noted we've been following this since mid-june is that the markets have been stair-stepping higher running up and pulling back running up and pulling back they've been making short-term cyclical highs higher highs and higher lows and for some as long as that is intact that their assumption for new trades might be well let me just go with that now I didn't intend to draw a rectangle here then we remove that drawing and switch up my drawing tool to the trendline tool but let's just say that we think that for the near term for the foreseeable future we think prices are more likely to go up than down obviously we could be wrong only time will tell but let's just say that we are bullish well that's going to remove neutral and bearish strategies from consideration for the time being all right so now is it more of a buyer's market or more of a seller's market what do you guys think let's go have a look at the vix the vix is a chart that some Traders will use to gauge whether options are comparatively inexpensive or comparatively more expensive okay and over the last seven or eight months here actually for through basically all of 2022 you can see if you look at where the vix level is at the moment there have been a few weeks here and there where levels have been lower and options generally have been less expensive but for the most part options have been pricier than where we are right now okay when the vix is low that generally indicates lower options prices when the vix is high it generally indicates higher options prices it doesn't apply to every single contract on every single security but it's a general it's a good General gauge all right so when we describe this more of a potential buyer's market or more of a seller's market well if our if our conviction is that prices are low and maybe less likely to go dramatically lower it's more of a buyer's market if we're way up here that might be more of a seller's market all right so let's just say that we're looking maybe toward buying options so let's just put those two pieces of the puzzle together for just a moment if we're bullish and we want to buy an option that is bullish what do we do well if we strip it way down to the basics when we're bullish we can buy calls or we can sell puts now obviously there are all sorts of variations on those themes different ways that we could structure fancier trades but let's just say we're going to buy a call all right well let's go to an example stock and maybe buy a call let's go to Walmart so here I just wanted to give you a quick uh technical backdrop for Walmart you really notice Walmart hit its low a little bit earlier than the markets it actually bottomed out around mid-may all those closely matched that in June we might have called that a double bottom and then we started to see a rally now as Walmart attempted to Rally it got up to an area where it had been before old price floor acted as a new price ceiling here for a bit through through the first the latter part of July first part of August bumping our heads against that and then an earnings announcement came in and gave Walmart the push it may have needed to get up and through that price ceiling and interestingly enough once we got through that ceiling that old ceiling is now acting as a new floor it seems to be right is that consistent with typical technical analysis assumptions it is okay so yeah I had to I I'll say for for the record on the archives my apologies to Andrew I don't know unfortunately what I could do to resolve your sound issue it does seem to be on your end so yeah I just don't have additional suggestions my apologies but let's just say that the trader thinks okay nice earnings announcement maybe some profit taking after a very strong run up in the for the foreseeable future let's say that the outlook for Walmart is consistent with our outlook for for the S P 500 and we think that we're likely to press higher now how much higher time will tell obviously obviously the stock could go lower we might be wrong but there's there may be some hints in history here let's pop up here to a three-year chart on Walmart this is kind of interesting where has the stock struggled to Rally above historically here we are maybe pushing higher right around that 152 level you can see we got up there once back here August of last actually August of 2020 and then again in November of 2020 and then again in August of 2021 and then again in November of 2021 and here we find ourselves August of 2022 will history repeat itself maybe the trader is building their their trade around that assumption but let's just say that we have that outlook for prices to rise now do we think they're going to go straight up there to 52 by tomorrow probably not okay um thank you heart man that that's very helpful uh we need to give this trade some time right if we look back historically these are weeks here boy it took a couple of months to go from where we are right now up to those resistance levels we've had a few touches there to give us a gauge for that two or three months let's say it's going to take us about three months potentially if it does get up to 132 that's how long they think it might get there so if we go if we were to go place a trade are we going to buy a contract that runs out of time in two weeks or five weeks or even two months no we're probably going to give that some time to work even going out here where we're giving it five months we might be getting into the back end of the trade time frame and having that time Decay really working against us let's give this trade through the 17th of March okay that's a 204 day contract and so for the first leg the first portion of today's example trade we're going to buy so this is going to be our example trade it's known as a long call diagonal but we're going to buy the 17th of March and you know with the stock trading around 135 what if we just buy the 135 call and that looks like that's trading between 1050 and 1080 let's call it 1065. now if we just did that if we just did this if we bought that long call is that a bullish position yep is it built around mine yes it is now is this a high reward potential trade or is this a high probability trade when buying long calls these are inherently High reward low probability long calls and long puts they all right across the Spectrum in the money out of the money doesn't matter which strike it doesn't matter which expiration they are universally lower probability strategies because of a couple of factors the initial spread between the bid and the ask and also time decay so they are a high reward lower probability strategy so we would only choose this if that seemed appropriate for our risk tolerance for what we for for uh you know our portfolio um needs but let's say that this is the structure of this trade so far okay this is an accurate um description of the conditions under which someone might choose to buy a long call now there's something working against this I already mentioned this time Decay right there's that time Decay element that's working against our long call it's just a sort of a fact of life when owning long options we have time working against us is there something that a Trader might do about that and as a matter of fact I'm going to introduce a second potential question and that is when we own a stock we can sell calls against that we have a covered position when we own the right to own the stock which is what we do here we might also be able to sell calls against that position that's what we're going to be doing to to uh reduce the the time Decay exposure you might have noticed on my chart I had a line let's go back to that one day or the daily chart so you can see this I had a line drawn here through this uh this broken resistance that now appears to be acting as new support I had a line drawn up here where we've had a price ceiling historically but in the interim there is another level level that maybe the trader might not ignore and that is right around that 140 level with just you know maybe a few hours or a few minutes here where the prices were above that in the short term there may be some resistance right there okay so if the stock rallies that's great that's helping our long call but what if we bump our heads right there and get a little bit of a pullback well that may introduce a second opportunity to do what we call diagonalize this trade this is going to be the second half of our trade I'm going to come back to our trade tab and in the short term where we see that shorter term resistance what if we think that's just going to be a near-term price ceiling maybe that gives us an opportunity to sell a call right around that level that was around 140. let's go to the 16th of September and I'm going to go to the 140 calls it looks like those are trading between 85 and 88 cents let's say we're able you know what I'm just I'm not going to be terribly generous to myself let's just say that we are able to sell that for 85 cents sell the 16th of September not September September not two s's either uh what was that the 140 call and let's say that we're able to get that for 85 cents now what's the purpose of this short call well think about this like a covered call has anybody ever heard this a diagonal spread those of you who are veterans at this strategy have you ever heard this described as being the poor person's covered call well with the covered call we typically buy a stock we let that stock run up but when we think it's going to bump into some resistance maybe we sell a call option right there because they're running up in the stock price think about this a run-up in the stock price is helping the stock but that resistance as long as we stay below that resistance and we sold a call at or above that then that call can expire worthless and maybe we get a little income at the same time we're getting the price appreciation right David you've heard this Suzanne yep Michelle Rebecca Dom Brenda's heard me call sorry I have a whisker that's kind of poking me in the corner of my mouth apologize for sort of playing with a quarter of my mouth there I think we got to take care of in any case yeah Suzanne we can potentially bring in an income and keep selling long calls uh but keep selling those short calls against that long position right so in this case we don't own the stock but we do own the right to own the stock which still creates the potential for a covered position okay so let's go back to our trade so now here if we were to do this trade what we now have is we have the right to buy shares for 135. through the 17th of March but for just the next 22 days through the 16th of September we also have an obligation to maybe have to sell shares at 140. so why are we why are we willing to take upon ourselves this obligation well it might be that between now and the 16th of September that's this red Dash vertical line we don't think the stock is likely to be above 140. what if the stock goes up
and bumps his head and pulls back as we anticipated so we cross that September 16th so we'll call that the finish line for that for the the short option what might happen with our trade well the stock has gone up from when we entered this trade what does that do for um what does that do for our long call the stock going up that helps our call right as long as time Decay hasn't offset all of the gains that we've made or maybe we see a big fluctuation in volatility but theoretically we should be probably in a profit scenario if this plays out right that's an if at the same time if the stock is still below 140 and we cross the September 16th Finish Line what happens with the short call it expires worthless so a short call expires worthless and we we sold it for 85 cents let's say it just expires but we keep that 85 cents that's a profit and we've made a profit on and all of these are theoretical until this actually plays out right um but we've also made a prob a profit on our long call so we're putting ourselves in a position to to uh profit in two possible ways now that sounds awesome but are there some potential drawbacks to doing this well yes just like with a covered call if the stock rallies further than we expect we're not really able to participate in that upside potential so we have the right to buy shares for 135 but for the next 22 days someone else has the right to buy shares from us for 140. so if the stock goes to 145 for example our long call making money but our sharp short call can be putting a drag on additional profits up here okay so that's a bit of a trade-off now another nice thing about this strategy is what if what if we were wrong right from day one what if the stock just sort of wanders around or even goes down well that's not good because we know that time Decay is hurting our long call and if we if we uh had only if we had just done that long call now we'd get it we'd be hitting time Decay damage and even our Delta just price is working against that long call well at the same time the price movement is working for the short call and time Decay is working for it even faster which which contracts have more time Decay the ones that are way out there in time or the ones that are closer to expiration we can actually see this if we go to our trade tab let's go to uh let's go to that 17th of March contract and look at this 135 call that we purchased and if we look at that time Decay we look at our Theta column it has a minus 2. so the next 24 hours we're positioned to lose about two cents if price doesn't move and if volatility doesn't rise or fall we lose about two cents to time Decay but if we look at the option that we sold let's go to the to the short option the 16th of September look at our strike at 140 it says four cents now it says minus four cents oh no that well that's what's happening to the buyers of these options we're the seller so that would be a positive four cents time Decay is working twice as fast in our favor on this trade as it is working against us having done this short option okay so um so that's quite that's sort of a more detailed discussion than maybe some of you might have been prepared at this moment in your in your options understanding careers to really absorb that's okay you can go back and watch this archive but but the one thing that I would definitely suggest is if if this your first time being exposed to diagonal spread just always go back to thought okay Cameron said it's kind of like a covered call it really is if you can understand a covered call strategy if you can get your if you can uh get a comfort level with that then this strategy makes a lot of sense it's just that instead of buying the stock and selling a call against it we bought a long option and we're selling a call against it Cola says what if Walmart goes to 140 tomorrow well that would be fantastic for our long call wouldn't it it wouldn't be terrific for our short call so um where would we hope that it goes from there well if they if the short call gets assigned which is always a possibility anytime that we sell a short option and let's address this right now and daddy says is this diagonal spread a debit spread yep it certainly is yeah because we're if we revisit the the facts of the trade I know that you're not seeing them right now but we paid 10.65 for the long option we were only paid 85 cents on that short option so that means 9.80 came out of our pocket to place this trade now what that really did is it reduced the cost the net investment in the trade so it's a little less expensive than just doing the the long call it's reduced that net cost and introduced a second way that we can make money on this trade okay of course at the same time it's put a cap on the upside potential of the trade too for a short period of time so they're always pros and cons to these strategies but yeah just always strip It Back to Basics if you're struggling with it think okay it's it's kind of like a covered call right so let's go back to our trade tab and um the final thing I want to discuss is the naming of this thing why is this known as a long call diagonal well the long Eddie actually refers to your question it's a debit spread we're net long we yes we have a long and a short position but which one is the bigger trade it's the long trade so we have that bullish bias it's built using calls that's the easy part why is it referred to as a diagonal spread well let's look at it this way the we have two op two options that are pretty similar right uh there's there we we bought an option we sold an option but they're on the same stock so they're similar but there are two distinctions between them there is price we bought our long option at 135 and we sold our short option at 140 so there's sort of a vertical distinction between the two and then there's a sort of a linear distinction between the two in the form of time so they're separated by price and then we have one that's out here in in um March we have a second one that's uh in September so price and time if we want to draw a line connecting those two now it kind of creates a diagonal now that's that's the visual that helps me with this but we just call it a long call diagonal spread but in effect what we're doing here is we're trying to enter into a less expensive covered call position if we wanted to do a covered call on Walmart we'd have to buy the stock right now it's 135 dollar stock not costing us 135 dollars it's costing us about 10 bucks right so we could have bought the stock for 135 and sold a call for 85 cents that would offer less than a one percent return instead of doing that we bought an option for ten dollars and we now are covered to still sell the same uh contract for 85 cents now that's more like um and eight percent somewhere in that neighborhood potential income right so let's place the trade how do we place the trade we have two legs on this strategy quick way to do this on thinkorswim is to just go down to the option you tend to buy and click on the ask price that creates a buy order now we're going to slip back up to the option that we intend to sell and we're going to hold down the control key on our keyboard so you can see me do that with my finger home hold down my control key on my keyboard and click on the bid price for the option that we intend to sell and that's going to create in order to buy 10 contracts and sell 10 contracts net cost is going to be around ten dollars this is a standard contract ten dollars per share times 100 shares about a thousand bucks that would be kind of a small trade for this paper money portfolio but I am going to dial this down a little bit how about we do five contracts it's gonna be about a five thousand dollar trade okay Peter says do you generally buy the at the money option when using the strategy Peter I could have gone deeper in the money I could have gone further out of the money the same pros and cons come with that decision as a typical buying a call option we get more expensive we go as we go deeper in the money but less time Decay and less leverage less leverage For Better or For Worse as we go out of the money we get less expensive options but more exposure to time Decay and greater leverage For Better or For Worse okay there are pros and cons to each of those decisions I just went without the money we didn't have to choose out the money but uh let's see what's the current uh the mid is at 9.75 I'm going to dial
this up say that we're willing to spend 980 to get into this trade anytime we submit a limit order there's a risky order might not fill but let's click confirm and send we're going to buy five of these diagonal spreads 17th of March of 2023 16th of September 2022. cost of the trade plus commissions here there are commissions on this going to be around 4 900 bucks if we can get this order filled but let's click Send and that's now in our working orders and we're in it okay so we said we'd pay up to 980. we got that for 9.79 . so what can happen from here well if the stock goes up there is a cap on our gains if the stock goes down we could lose our investment that was already the case when we buy long option so we have to be aware of that okay but that's uh that is oh man I just had an unintentional pun come to my mind and now I can't get out of my head so long and short of a diagonal spread I I didn't plan that I just had to say it once it was there but everybody we're gonna see how this goes from here for for now we have a preference for the stock to go up a bullish bias and ideally for it to stay below 140 as we cross that September 16th expiration if this contract expires worthless if the short option that expires worthless well then what what do we have we just have a long call option and the higher it goes from there the better for the trade um we could also sell it another short option against that if we choose to at some point in the future me neon are you booing my Pawn I'm sorry all right okay everybody uh I really want to emphasize here we do have a short option in this trade it could be assigned at any time if it is assigned that means that someone has the right you know to buy in this case 500 shares of Walmart from us would we exercise our long option to cover that probably not what we'd probably do is just buy the stock just on the Open Market at that point Eddie says is there any conditional trade on this trade there's not at this moment Eddie but if the stock starts to collapse that's not what we want we'll keep an eye on that okay yeah the stock starts to rise that's just what we're looking for we have that bullish bias we'll let that we'll let that go okay time for me to let you go everybody thank you for giving me your time today this is what we do on Thursday mornings if you want to put it in your personal calendar to join me and Pat we talk about selecting option strategies conditions under which we might choose those when we kicked off today's discussion we wanted to go through those three Market related questions bullish bearish and neutral is it time to be buying or selling options or and finally High reward versus high probability we'll look at the markets to get a quick gauge on those and we placed that example strategy today it was all about long call diagonal spreads it's not always about long call diagonal spreads next week it'll be a different strategy so hopefully you'll join me then um as you go just remember that risks are real we did use real examples in today's discussion it's not a recommendation or endorsement of those Securities or those strategies you're invited to join me in my regularly scheduled sessions in other days of the week so Monday Tuesday Wednesday Thursday I have something on the calendar on a range of topics so you can finally uh there and a final thing that I wanted to point out is that if you're not subscribed to the channel pop right down here click on the Subscribe button it helps out our Channel it also just helps you find your favorite instructors and your favorite webcast series much more efficiently it takes one second to do it so just go ahead click that little subscribe button right now if you don't see that you might have to look a little bit further down here in the in the layout on YouTube and click on the red subscribe button also follow me and Pat on Twitter at P malali underscore TDA at CME underscore TDA I'll be on Twitter later today checking up see what people are talking about maybe make some comments about the markets but everybody thanks for giving me your time today go enjoy the rest of our educational webcast we have a lot still on the uh on the docket uh but I'll look for you on Twitter I'll also look for you in my other webcast but Hey whenever I see you again until that moment arrives I do want to wish you the very best of luck happy trading bye [Music] [Music] thank you
2022-08-29 09:50
