One of the most predictable things in the market is time decay after a big event like earnings. Have you ever used a diagonal spread to capitalize on the change? Today we’ll see how it’s done.
First, remember that option premiums attempt to factor in price swings. As a result, they cost more before big events like earnings and then lose a bunch of value after the news passes. See this earlier post for more.
Tech giant Apple (AAPL) is setting up an opportunity to see how this works because earnings are due tomorrow night.
The screenshot below of shows contracts expiring this Friday, August 3, and next Friday, August 10. You’ll quickly notice higher implied volatility in the shorter-term options (see yellow ovals). Next, the 195s expiring this week only cost $0.40 less than the calls expiring next week. Remember that richer time value will be crushed as soon as earnings hit. Why not sell them?
Make sure to revisit Market Insights on Wednesday for an update to this mocked-up trade.
Next, the diagonal spread involves the purchase of longer-dated contracts that are closer to the money. So, you buy the 10-August 192.50 calls for $3.70 and sell the 3-August 195s for $2.13. That’s a net cost of $1.57.
There are a few ways this can play out:
- Say AAPL rallies through $195. The 195s you’re short will lose their time value but gain intrinsic value as they go in the money. But you’ll also make money on the 192.50s. Holding through the end of the week will let you collect $2.50 (the difference between $192.50 and $195). That’d be a 59 percent return on your $1.57 outlay.
- Say AAPL crashes under $190. The 195s you’re short will become nearly worthless, which is good. The 192.50s you own will also lose value, but more slowly. In other words, you’re partially hedged.
- Say AAPL is little changed after the report. In that case the short-term 195s you sold will lost their time value much faster than the longer-term 192.50s you own — resulting in profit. The other cool trick is that you can close the 195s and sell more expiring a week out to collect more income. That would turn the diagonal spread into a vertical spread. (See our Knowledge Center.)
The most important things to remember about the diagonal spread is that you want to own options that are closer to the money and longer dated. You sell contracts that are further from the money (with puts that means lower strike) and have less time to expiration. Traders should also be consider adjusting their position after the big event plays out.
The greatest benefits of the diagonal spread are the different speeds of time value and the fact they’re easier to adjust. They’re usually less profitable than straight vertical spreads in the event of a sharp rally. But the different speeds of time decade make them easier to adjust, which in some circumstances can open the door to bigger profits down the road.