Demystifying the Call Diagonal with XLE

• Posted by Greg Harmon
• on April 8th, 2016

Friday morning I wrote about how the embedded Cup and Handle Patterns in the Energy ETF ($XLE) pointed to a potential huge move about to happen here. The trigger occurred shortly after the open. At that point one could participate in the upside by buying the ETF.

I hold the ETF in client accounts but started talking with a subscriber to the Premium Service about an options strategy to play for the upside. The result was a September 63/May 65 Call Diagonal. I ended up putting on this trade in my personal account.

Before your eyes gloss over from the options lingo lets break it down and discuss how to manage it through time.

The Trade

XLE Sep 63/May 65 Call Diagonal for $2.60. This is nothing more that buying a September 63 Call and selling a May 65 Call. The logic for buying the September 63 Call is easy. I call this the Driver of the trade. Owning that call gives me upside price participation for the next 5 months if the stock continues to move higher. The benefit of the option over buying the ETF is that I have capped my risk at the cost of the option, or the premium, in this case $3.50. You can view this as equivalent to buying the ETF with a stop that is $3.50 below your purchase price.

Once I have picked the Driver then I look for another option that I can use to Fund the trade. This is where the May 65 Call comes in. By selling the May 65 Call for 90 cents I lower my cost to $2.60 for the position. This is a 25% cost reduction. Adding the Funding options comes with a cost though. Now if the ETF moves higher quickly, above 65 by May my gains will be capped.

Managing the Trade

Now that the trade is on the books there are 3 things that can happen. The ETF can move up, down or sideways. The only thing that we can be certain about the trade is that both options will lose some time value every day. Let’s break down the different paths.

ETF moves up: This is a good thing. The timing of a move higher is what is important now. On a fast move higher, over 65 before May expiry, the short May 65 Calls will need to be bought back to close. To fund this purchase we will then look to sell June or July Calls with a higher strike, in essence making a new Call Diagonal. This also raises the cap on the gain on the trade. You may have to do this several times during the life of the trade, and if you can raise the cap and also get a net credit even better.

If the ETF does not exceed 65 by May Expiry then those calls will expire worthless. This will leave you with the ability to sell new June Calls and collect back more of your premium. This also may be done several times.

ETF moves sideways: If the ETF moves sideways then the short calls will expire worthless. Then just like the slow rising case above, you have the ability to sell the next month Calls to collect more premium. Imagine doing this 4 times and getting 25% of the initial premium each time. You would end up with a free trade whether you were right on the ETF direction or not.

ETF moves down: This is basically the same as if the ETF moves sideways, but with one twist. In the initial trade as well as the scenario where the ETF moves up and or sideways, there is no margin needed in your account. you just need to be able to pay for the trade. If the ETF moves down you can get into a situation where there is added margin cost. If the ETF drops to say 60 at May Expiry the short May 65 Calls will Expire. You will still own the September 63 Calls, but they will be $3 out of the money and need to get to 65.60 to pay you at Expiry. That is a 9.3% reversal in a ETF that is falling at that point.

In this scenario you can shift the short term strategy to collecting back your premium outlay. Selling June 63 Calls might get some, but selling June 62 Calls will get more. This is where added margin comes in. If you go forward with a strategy to collect back the premium paid and the ETF is falling then, you will need to sell progressively lower and lower strikes as time goes by in the June, July and August expiry’s. Once the strikes move below the strike of the long call, the September 63, your broker will hold margin for the differences in the strikes. This may not be much for a slow grind lower, but at a price of 50 it could get large.

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