CALL DIAGONAL LEAP SPREAD STRATEGY

Joseph R. Stadelnikas, M.D., M.B.A.

07/15/08, revised 03/15/15

TRADE SET-UP

There are two dangers trading diagonals. One is the vega effect on the long call and the
other is the delta effect when the short calls goes ITM. This strategy minimizes or
eliminates both effects.

1. Purchase a long call

Approximately 12 months to expiration, further out if bid/ask spread not too great

Strike with a delta of -0.80 to -1.00

2. Sell a short call

Sell at the critical strike: leap strike + premium paid

ie. If leap strike = 80 and premium = 36, critical strike is 116

This is for the initial strike only, below will show how to calculate subsequent strikes for
short calls.

Never sell a strike below that strike

Expiration ~ 30 days to expiration (dte)

You desire to purchase 5000 shares of IWM. You decide to purchase 50 contracts
January 2016 leap instead.
INITIAL TRADE SET-UP

Prices end of day January 21, 2015, IWM @ 115.84

Cash available to trade: 120000

Set a Goal! Everyone will have a different goal but for this example I am going to set one
of 10% annual return on the total cash available. That would be 12000 a year or 1000 a
month.

Purchase Leap:

Jan16, 80 strike, 36.34 (mid), delta -0.96, tv = 0.50), 10 contracts, total cost = 36340.
Time value (tv) = 10*100*0.50 = 500. Days to expiration = 358

Equivalent stock purchase is 1000 shares * 115.84 or 115840

Place in cash account the remaining cash. ie. 120000 36340 = 83660

That cash will be used for 1) roll leaps out to next leap year and 2) add additional leap
calls when necessary.

Initial Short Call:

Any strike above your cost basis plus leap strike, ie. cb = 36.34 plus leap strike = 80;
36.34 + 80 = 116.34

Pick strike based on your return goal.

Expiration approximately 30 dte; for this example: feb 20 call strike 117 @ 2.12.

How many contracts? Ratio of shorts:longs based on leap delta. I usually dont go above
8:10, but with this example one could do 9:10 because of leap delta of 0.96. For this
example, we will sell 8 contracts.
8*100*2.12 = 1696

Time value paid for leap was 500 so after paying for time value 1196 collected in
premiums.

So to summarize initial set-up:

Initial cash 120000

Jan16, 80 strike, @ 36.34, 10 contracts 36340 initial cost
Feb15, 117 strike, @ 2.12, 8 contracts 1696 premiums collected
Cash remaining = 83660

Trade Management:

Short call expires worthless. Do nothing with the leaps and sell another monthly call.

Before selling another call one must always calculate appropriate strike, the critical
strike. The strike to sell can change based on the current leap value, the current leap
delta and if one sold a leap to cover an in-the-money short call previously.

1) Calculate Adjusted Cost Basis

Adjusted cost basis = Sum BTO Leaps + Sum BTC SCs Sum STC Leaps
Current # Leap Contracts * 100

In this example, no leaps have been sold so our adjusted cost basis is our original cost
basis of 36.34

2) Calculate Critical Strike

Critical Strike = Current stock price + (Adj CB Current Leap Value)

Current Leap Delta

For this example, lets say leap value dropped to 34.34 because IWM decreased in
value from 115.84 to 113.84. Since we sold no leaps to pay for ITM short calls our
adjusted cost basis is the original of 36.34. Our current leap delta is 0.95. Our critical
strike would be:

113.84 plus (36.34 34.34) / .95 = 113.84 + 2.1 = 115.94

Rounded up to 116

Sell short calls at strike of 116 or higher and at a ratio of current leap delta, I prefer
however, not above 0.80.

Short call is ITM

If you sold at a ratio, your long calls have appreciated as well. Simply calculate the
amount of money your obligated to close on the ITM short calls and then sell the
number of long calls needed to pay that obligation. Rarely, is more than one (1) leap
necessary to STC. Then continue as above, calculating your adjusted cost basis, which
has now changed and calculate the critical strike. Then sell monthly short calls at that
strike or above that critical strike and at a ratio of your leap delta.
If you cannot receive enough monthly premiums to meet your goal because the critical
strike calculated is too far out of the money, then buy enough new leap calls to sell short
calls against to meet your goal. (another reason to keep the unused cash)

Rolling Long Leap Calls

When the long calls have about 90 days to expiration, roll your long calls to the next leap
available, in this example, that is Jan17. You can roll to same strike, however if IWM has
appreciated you can usually increase the long leap call 5 or more strikes and still have a
leap delta over 0.80 and with no additional money added. If you roll to the same strike,
you have a cost of the added time value. That is usually 2-3 dollars per share, so for
1000 (10 contracts), the cost is about 2 to 3000 per year. (another reason to keep the
unused cash). If there is a major market correction, you should have enough cash to roll
leap calls for 5 to 10 years. This will allow you to ignore the ups and downs of you leap
call value.

Diagonal Risks

Directional
Vega
Delta

Control last 2
Manage 1, keep unused $ in cash to add to new leaps during corrections and to roll
leaps out.