Can You Spot Them?

In the September 23rd Seasonal Forecaster newsletter I introduced a new trading strategy, the ‘rolling diagonal'. This strategy is essentially a covered call using a long call in place of buying the stock. It has been called various names, including synthetic covered call, a diagonal, a diagonal calendar, and more. I think of a covered call using all options as a diagonal, and when trying to capture several consecutive months of income by rolling from one short call to another, I think of it as a ‘rolling diagonal'.

In the September 23rd newsletter I focused on the first rolling diagonal trade, involving a Seasonal Forecaster favorite – Ecolab (ECL). The trade was buying January 90 calls and selling October 97.5 calls. On October 14th, I covered how the Oct 97.5 call could be ‘rolled' to a November 100 call, as ECL had gained a bit and October option expiration was approaching. While I addressed how the ECL diagonal could be managed on through the expiration of the January long call, because the position had gained so much so quickly (the trade was up 25-28%), I suggested closing it out and taking the profit.

The second rolling diagonal trade I presented was on September 27th, focusing on buying Lennar January 31 calls and selling October 37 calls at a 5.6 limit (a debit), when LEN was at 36.49. LEN was near previous resistance and was forming a likely trading range pattern. The volume pattern on the stock was showing volume on up-close days overwhelming volume on down-close days. LEN, like other homebuilders, had a strong seasonal tendency to rise through the end of the year.

That diagonal spread was priced around 5.51 on the open on the 27th, making the cost basis on the trade 5.51.

The intent of the trade was to keep the Jan 31 call and let the short call expire or roll the short call into farther-out months just like one would do with a covered call.

In the October 14th newsletter, I suggested rolling the October 37 call over into a November 35 call, as LEN had retreated a bit into the middle of the trading range. At the open, that roll provided a 1.3 credit. This lowered the cost basis on the trade down to 4.21. As long as the price of the January 31 call closed above 4.21 at January expiration, meaning LEN closed above 35.21, this trade would make money.

The November 35 calls expired worthless since LEN closed at 34.17 on November 15th, the last trading day for November options. In the November 18th newsletter, one of the options I covered for what to do next was to wait until LEN got closer to the high of the recent trading range, in order to capture a higher premium when selling a December call.

In the November 27th newsletter, following the previous day's 5% jump in LEN, I suggested shorting a December 37 call to bring in an addition .83 in income. That brought the cost basis on this trade down to 3.38 (if all of the December 37 call premium was eventually captured).

In the July 22nd newsletter, I covered a seldom-mentioned benefit of covered calls – the fact that even though they don't usually have high returns, covered calls can keep you ‘in the game' for big moves. That works with synthetic covered calls as well, such as my rolling diagonal.

In the December 16th newsletter, with just 5 days left until December option expiration and only .25 in time value left in the December 37 calls, I recommended closely watching LEN over the next few days. If LEN stayed below 37 until the Dec calls expired, then January calls could be shorted for one final chunk of income.

But if LEN rose above 37 the short Dec 37 calls could be in danger of being exercised. Instead of rolling out one final time, I suggested the trade should be closed and the profit booked. The small amount of income from doing one more round of short calls, in my mind, wasn't worth the chance LEN could fall within the next 30 days and take back the nice profit this trade was sitting on.

On Wednesday, as the markets jumped in response to the well-received Fed and housing starts announcements, LEN logged a 6.3% jump on very strong volume. Towards the end of the day, LEN was trading above 37. At first, the time value in the Dec 37 calls was above .40, but then began to fall to near .20. Following my analysis in the 12/16/2013 newsletter, this would have been the time to close the trade. For end-of-day traders who were not able to watch and trade intraday, Thursday morning's open provided a similar opportunity to close the trade. The worst case credit the trade could have been closed for was around 5.56. With the cost basis down at 3.38, and .34 required to buy back the Dec 37 call, the effective profit on the trade was 5.56 – (3.38 + .34) = 1.84, which was a 49.5% profit.

In my above description of this trade, I mentioned several points I've covered in the newsletter over the past year related to how to increase the probabilities of the trade working out successfully. Can you spot them?

It's seldom one thing that makes the difference on a trade. Successful traders get consistent results by thinking about how to raise the probability of success on every detail of every trade.

Of course, there's much more you need to know and many more stocks you can capitalize upon each and every day.  To find out more, including the answer to the above question, type in www.markettamer.com/seasonal-forecaster

By Gregg Harris, MarketTamer Chief Technical Strategist

Copyright (C) 2013 Stock & Options Training LLC

Unless indicated otherwise, at the time of this writing, the author has no positions in any of the above-mentioned securities.

Gregg Harris is the Chief Technical Strategist at MarketTamer.com with extensive experience in the financial sector.

Gregg started out as an Engineer and brings a rigorous thinking to his financial research. Gregg's passion for finance resulted in the creation of a real-time quote system and his work has been featured nationally in publications, such as the Investment Guide magazine.

As an avid researcher, Gregg concentrates on leveraging what institutional and big money players are doing to move the market and create seasonal trend patterns. Using custom research tools, Gregg identifies stocks that are optimal for stock and options traders to exploit these trends and find the tailwinds that can propel stocks to levels that are hidden to the average trader.

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