Finding the Best Price on a Verticle or Diagonal

[tjlocke99 18]

I would love some feedback on this.

I purchased an AAPL bullish diagonal and bull call spread about a month ago and despite the stock going up my positions did not increase as expected. In both trades I had an ITM long at a strike of around 630 and a OTM short around 680 with the stock was around 660. What happened was that the OTM short somehow increased in value just slightly less than the ITM long position (in absolute dollars) and thus my gains were minimal.

What I started to notice recently just by looking at some option tables is that some strikes seem to have a "better price" than other strikes with the same expiry. Rather than describe this in detail I now realize that there are likely better diagonal and vertical positions I could enter if I am bullish or bearish on the stock that will be more profitable. However I am not exactly clear how best to analyze the trade that is the best value.

Let me use AAPL (Apple computer) as an example.

If I want to enter a bullish AAPL diagonal am I better off:

1. Buying a deep ITM call and selling an ATM nearer month call?

2. Buying a near ATM call and selling an OTM call?

3. Buying an ATM LEAP and selling an near ATM call.

. . .

There seem to be hundreds of possible combinations.

Could someone help me or point me to a resource that would help me understand this better?

One mistake I know to avoid is do not be short an ATM or near OTM call that expires just after an earnings announcement or major product launch. The IV increase will also eat into your profits even if the stock goes up.

Another thing I know is deep OTM options lose most of their value PRIOR to the final 30-40 days before expiration. As far I know this NOT true of ATM or slightly ITM options which decay the most in the final 30 to 40 days.

Therefore this leads me to believe that typically if the short in my vertical or diagonal is going to be around 2 months out, then I want it to be reasonably far OTM so that if the stock remains flat I can still breakeven or even make a small profit.

Thank you VERY MUCH for reading this.

Richard

[Kim 7,475]

Richard,

Many traders think that diagonals behave similar to covered calls. This is not true. Covered call will make the maximum gain at OR above the short strike. Once the stock reaches the short strike, the gain remains the same even if it goes much higher.

This is not the case for the diagonal. In order for the diagonal to have a similar P/L profile, the long option has to be deep ITM (have delta close to 1). If the long option has delta much less than 1 like in your case, the maximum gain is achieved at the short strike (680 in your case) but above this point, the gain actually becomes smaller. The reason is that once you reach the short strike, the delta of the short option which has closer expiration starts to increase much faster than the delta of the long option. The whole trade actually becomes delta negative at some point.

Of course there is a tradeoff for each combination. Selecting a deep ITM long call will cost you much more and give you less leverage, but it is also much more conservative. Same for the short call - going much further OTM will produce more gains if the stock surges.

The most important thing to remember: diagonal produces the maximum gain if the stock is near the short option at expiration. Not above, but as close as possible. So you should choose the short option based on your outlook where the stock will be.