DIAGONAL LEAP SPREAD PORTFOLIO STRATEGY An Income Strategy

Joseph R. Stadelnikas, M.D., M.B.A. Updated 07/15/2008

Biography

Undergraduate: United States Military Academy, West Point, B.S., 1970

Graduate: Columbia University College of Physicians & Surgeons, M.D., 1975

Graduate: University of South Florida, M.B.A., 1995

My focus has been on developing a retirement strategy. This is a strategy that is not going to give fixed income returns, but rather

equity returns with less risk. I have been refining diagonal spreads for over 16 years to meet those goals. (23 years option trading experience).

My goal is for a 15% OVERALL return for my entire portfolio.(Return will be much greater with the diagonal leap spread portion)

For example:

$100,000 portfolio $40,000 in diagonal spread options – 30% annual return = $12,000 $60,000 in fixed income – 5% annual return = $3,000Total Return = $15,000% Annual Return = 15%

These returns are possible with the Diagonal Leap Spreads (DLS) strategy if the rules are followed and good money management used.

STEP #1

Develop a core buy-and-hold portfolio on paper just as you would if you never intended to trade options. Typically, this would consist of using asset allocation and diversification across different equities and fixed income classes. This would consist of assigning a total amount of money for the entire portfolio. Assign a percentage for each asset class and position and then assign a dollar amount to each.

THIS IS A CRITICAL STEP !!!!!!!!!!THIS IS WHAT WILL MAKE THIS STRATEGY LESS RISKY

THAN A BUY-HOLD STRATEGY!!!!!!!!

I believe the best equities to use in this DLS strategy are diversified ETF’s that have large trading volumes. Best one’s IMO: SPY, IWM, EFA, EEM. All these funds are diversified, ie. they aren’t made up of stocks in the same industry or same sector. I don’t like ETF’s like QQQQ, mostly tech stocks; XLE, all energy; XLF, all financial,,,,,,,etc. I want a broad mix of stocks in an ETF.

SPY – US large cap equitiesIWM – US small cap equitiesEFA – International developed country equitiesEEM – International emerging market equities

For the fixed income portion one can use AGG. This investment seeks investment results that correspond to the price and yield performance of the total United States investment-grade bond market as defined by the Lehman Brothers U.S. Aggregate index. There are many other fixed income modalities, including a low fee money-market fund, many offered by Vanguard.

Let’s take a retiree with:

CAPITAL AVAILABLE: $1,500,000

One needs to allocate amounts to equities and fixed income.

CHOSEN ASSET ALLOCATION:(example only!) 66.7% FI…fixed income…$1,000,000

Of the remaining 33.3% maybe one may want the following.

40% LC...large cap US equities…13.32% or $200,000 25% SC...small cap US equities…8.33% or $125,000 25% ID...international developed countries…8.33% or $125,000 10% IE...international emerging markets…3.33% or $50,000

Total Invested = $1,500,000

For the sake of simplicity, I will use SPY as our choice of equity for the entire equity portion for this example. I will allocate all $500,000 to SPY to keep things simple. But the principles apply to the other ETF’s as well.

As of this writing, 07/13/2008:

We need to now calculate the number of shares for each equity asset that we want in our buy-and-hold portfolio. In this example, for simplicity, we chose to use only SPY. Since we allocated $500,000 and SPY is trading at $123.84, we would have purchased 4037 shares.

SPY = $123.84Leap = Dec 2010 - Strike 90 = $40.23Short Call (SC) = August $124.00 =

$4.00

STEP #2

We now need to establish a minimum acceptable monthly income goal before we establish our DLS portfolio. This is a personal decision. What I will use throughout this example is $5000 per month. This income must be less the decay of our leap time value that occurs during the duration of our short call (SC). For example, if our SC premium was $5400 but the TV decay of our leap was $1000 during the duration of our SC, our net income would be $4400 and our goal of $5000 would NOT be met. You can calculate the TV decay of your leap by using a spreadsheet or using an option calculator that is readily available free online.

MONTHLY INCOME GOAL = $5,000

We are now ready to establish our initial DLS position. We first must determine:

What leap expiration for surrogate option for selling covered calls?

I go out to the furthest expiration available, currently December 2010 for SPY. The theta of the leap is minimal and the time value per day I am paying is small. The cost for a DITM leap is much greater than ATM leap. Since there is very little time value in a DITM leap, there is little vega effect. Vega effect is a major risk using diagonal leap spreads and it is minimized, but not eliminated by using DITM leaps. That is, changes in implied volatility will not have the same effect on leap value than if an ATM leap were chosen as a surrogate. Remember, there are no freebies in trading options. If you think you found something that gives you more return, trust me, it also comes with more risk. You always give up something, if you get something. Since I use DITM leaps, furthest expiration and diversified index ETF’s, I am willing to have a little more money on the table. What do I get? The smaller theta and the smaller time value.

What strike price for leap?

I look for a leap with a delta of 0.80 or greater. Simple.

So, I would select the December 2010 - $90 strike which has a delta of 0.81. Why so DITM? Remember, one can continue to write short calls against that position all the way down to $90. When someone purchases ATM strikes for the leap, the cost is less in the short term, but with a small correction in the underlying one may not be able to collect premiums from the short call (perhaps for many months). That destroys the whole purpose of this strategy. ie, retirement income. I require the leap chosen have a delta of at least 0.80 for a reason. This is important because I do not sell short call contracts equal to the number of leap contracts. This allows me to avoid another real risk of diagonal leap spreads (DLS), a major upward move in underlying stock price. If you sell 1:1 ratio of SC:Leap, you could begin to lose money when the underlying price goes above your SC strike price. The reason is that your leap value will not appreciate $1 for every $1 of underlying price increase. Leaving some SC’s uncovered allows for the overall position to increase with the increase of the underlying price.

How many contracts of the leap should we purchase?

Above we allocated, in our buy-and-hold portfolio, $500,000 and for this example we allocated all $500,000 to SPY. SPY at $123.84 we would own 4037 shares (500,000/123.84). Each contract in options has 100 shares. Therefore, we would have 40 leap contracts (rounded down). The delta of the December 2010 - $90 strike leap is 0.81. An equivalent stock position (ESP) would be 40/0.81 or 49 contracts. The current market value of the leaps is $40.23/share. The total cost to purchase would be 49*100*40.23 or $197,127.

That means we have the equivalent stock position of $500,000 with $197,127 invested and at risk. Remember NO leverage!!!!! Don’t be greedy or you will be sorry. Place the remaining $500,000 minus $197,127 or $302,873 into a fixed income asset and a fixed income rate of return!!!!! Do NOT leverage!!!!  So where are we? We wanted to invest $500,000 in SPY. We are long leaps (stock surrogate) of $197,127 with $302,873 in safe fixed income with the potential of equal return or better with less risk. I like this so far.

IMPORTANT!

Put the cash above into a SEPARATE cash account from the fixed income portion of your buy-and-hold portfolio. We will be using the unused cash portion above for two purposes:

1. to roll out our leaps to a further expiration when they become available

2. to purchase additional leap contracts when our minimum monthly income goal can not be met

How much should we allocate to each of these purposes?

Purpose #1: Rolling (BTO a new further expiration leap, STC current leap) an option forward is inexpensive because the investor is selling an option with similar characteristics at the same time. I allocate 30% of the leap cost to rolling. Why that amount? The annual roll forward cost is unknown, but you could use the cost difference between the December 2009 and December 2010 – both strikes of $90 as a proxy. That difference, today, is $3.15. We have 49 contracts (4900 shares). The annual cost would be $3.15 * 4900 or $15,435. 30% of $197,128 (the cost of SPY leaps in this example) is $59,138. This amount would allow a roll of 3 or 4 times (years). Remember are initial leaps are 2-3 years in length with the ability to roll 3 or 4 additional years. That is 5 to 7 years and will allow us to weather any correction in the original market value of the underlying equity (at least historically) and hence our leap while collecting monthly income.

30% or $59,138 allocated to rolling

Purpose #2: Purchase additional leap contracts when our minimum monthly income goal can not be met.

Remaining DLS cash ($302,873 - $59,138) or $243,735 allocated to purchase additional leaps during market corrections

Let’s pause here at step #2 and look at our portfolio.

TOTAL PORTFOLIO VALUE = $1,500,000

Fixed Income = $1,000,000DLS = $500,000

DLS-SPY Leaps = $197,127DLS-Cash (separate account from above) = $302,873

Rolling = $59,138STO New Leaps = $243,735

Important: With a portfolio value of $1,500,000 we have at risk ONLY $197,127 or 13.14% not $500,000.

Above we calculated the approximate annual cost to roll out one year to be $15,435. We have $302,873 in our DLS-Cash account. At 5% interest the amount of interested collected would be 5% * $302,873 or $15,143. Therefore, rarely does new money have to be added in order to roll on a yearly basis. And one can usually increase the strike $5 for our leap for a roll for NO additional cost.

So where does the income come from each month? You are retired and need money! Social security isn't going to help! 100% in bonds won’t help either.

STEP #3

SELL COVERED CALLS AGAINST THE LEAPS PURCHASED(ie, Covered call with Leap as Surrogate for Stock Ownership).

What strike for the short call?

This is the easy part. I select the strike with the most time value. That is either the first strike ITM or the first strike OTM.

What expiration for the short call?

The near month call option, if there is at least 15 dte (days to expiration). If not, go to the next month. (>15 days <45 days)

How many short call contracts do we sell?

One risk with diagonal spreads is the upside problem. I avoid it. I hate risk. How to avoid it? Sell enough short calls to give you a position delta ratio of 2.1 or greater. (long position delta divided by short position delta).

Calculation:

# Contracts = # leap contracts * leap delta Delta ratio * short call delta

You choose the delta ratio: 2.1 is acceptable

To make things as simple as possible, use the leap delta. For example, if your leap delta is 0.73 use 7:10 ratio (averaging down). If the delta is 0.87 use 8:10. If the delta is 0.91 use 9:10 ratio. The important thing here is that you want enough uncovered leap contracts so that regardless of how high the underlying index increases during the month, the overall DLS position continues to increase and not decrease in value.

This means that I will enjoy capital appreciation of SPY even above my strike price of $124 with my overall position. The 10 leap contracts that do not have short calls sold against them will increase $0.81 for each $1.00 increase in SPY. No matter how high SPY increases that month I will not lose money in my overall position. I will continue to increase my return with each dollar increase in SPY, but less than if I owned outright the equivalent shares. Therefore, my upside risk has been eliminated. Critics of this strategy always cite the upside risk. By not selling 10:10 ratio, but adjusting the ratio based on our deltas, this upside risk is eliminated.

Today 07/13/2008, since there is only 5 days to July expiration, we will use the August expiration for our SC’s. With SPY at $123.84 we will sell the $124 strike calls since they are the one with the largest TV. We will sell at a 8:10 to our leaps. Our leaps are 49 contracts, therefore 49*0.8 is 39 SC contracts to be sold.

The $124 August 2008 SC’s have a premium of $4.00 bid. Therefore, $4.00 * 3900 is $15,600 in SC premiums collected. Using my

spreadsheet or any other option analyzer software calculated the Leap TV decay for the 34 days to August expiration to be $1175. Or simply look at option quotes from numerous free online websites and look at the current theta for your leap. In this case, our leap theta is 0.0071. Therefore, 34 days * 0.0071 dollars lost per day as a result of decay * 4900 shares is = $1183. That is close to what my own spreadsheet calculated.

The Net Return ($15,600 minus $1175) is $14,425. This is above our $5,000 minimum monthly required income.

Our Net Capital Invested is $197,128

Return If No Change in Underlying Index is ($14425/$197128) = 7.32%Annualized that Return is 7.32 * 365/34 = 78.56%

The DLS position has downside protection of 7.9% (15600/197128)

Our leaps have an initial TV of $6.39. ($90 + $40.23) minus $123.84Leap Strike (ITM) + Leap Premium – Stock Price = Time ValueTherefore, 49.8% of the leap TV is covered in our first sold call.($4.00*3900)/($6.39*4900) = 49.8% and we have 29 more months to sell calls against our leaps collecting monthly income.

TOTAL PORTFOLIO VALUE = $1,500,000

Fixed Income = $1,000,000DLS = $500,000

DLS-SPY Leaps = $197,127DLS-Cash (separate account from above) = $302,873

Rolling = $59,138

STO New Leaps = $243,735

Initial DLS PositionSTO – 39 contracts Aug 08 - $124 @ $4.00 = $15,600BTO – 49 contracts Dec 10 - $90 @ $40.23 = $197,128Decay Leap = $1175Net Premiums (income) = $15,600 - $1175 = $14,425

Important: With a portfolio value of $1,500,000 we have at risk ONLY $197,127 or 13.14% not $500,000.

We now have at risk ONLY ($197,127 - $15,600) or $181,528 or 12.1% of our entire portfolio value of $1,500,000.

The remainder of our 8 STEPS outlines how we manage our money and our initial DLS position after it is established.

STEP #4

At August 2008 expiration, if the SC is OTM, simply let it expire worthless. If the SC is ITM, then you need to BTC. I usually do this Wednesday or Thursday of expiration week to avoid assignment.

Let’s say at August expiration SPY is trading at $126.00. The SC would be trading at $2.00. $2.00 times 3900 shares (39 contracts) would be $7800 cash needed to BTC.

I do NOT put new money into positions as the underlying stock is increasing. Remember you want to buy low and sell high. Therefore, I will sell enough leap contracts to cover the above cost of

$7800. Our $40.23 leap would be worth approximately $41.83. (0.80 delta times $2.00 = $1.60 added to the $40.23)

How many leaps to STC? $7800/$41.83 or 186 shares or 1.8 contracts rounded up to 2 contracts.

STEP #5

Calculating Adjusted Cost Basis of Leap

First determine your total net investment to date. Sum all your BTO leaps add all your BTC SC’s and subtract all STC leaps. This will be the total amount of money you have invested in the position. Divide that total by the number of current leap contracts * 100. This will give you the current adjusted cost basis.

Adjusted Cost Basis = Sum BTO Leaps + Sum BTC SC’s – Sum STC LeapsCurrent # Leap Contracts * 100

STEP #6

If the current leap value is greater than the adjusted leap CB calculated above continue to STO SC’s as in Step #3.

As you STC leaps to pay for the cost of ITM SC’s the adjusted CB will be higher than the current leap value because of the delta of the leap is not 1.0

As the difference between our adjusted CB and the current leap value widens, whether due to a drop in the underlying stock price or because of the above delta effect, we need to adjust what strike price we choose for the next near month STO SC’s.

Remember, if our SC’s go ITM and our adjusted leap CB is above the current leap value we will be losing money on those leaps if we have to STC to cover cost of ITM SC’s. We need to adjust our SC strike to avoid that possibility.

Therefore, if we take the difference between the adjusted leap CB and the current leap value and divide by the current leap delta, add that difference to the current stock price to choose a strike price, we would avoid that possibility.

Why? If the underlying stock reaches that particular strike, our leap value should increase to approximate our adjusted leap CB.

You may consider, (if adjusted leap CB is greater than current leap value) STO SC’s to Leaps at a ratio of 10:10 to maximize monthly income.

Example: (NOT current values)

Our stock price is $124.50; adjusted leap CB is $42.00; current leap value is $40.00 with a leap delta of 0.80; ($42-$40)/0.80 = $2.50

Add that $2.50 to our stock price of $124.50 = $127.00 (Choose that as next SC strike). If the underlying increases to $127.00 at SC expiration, the current leap value should approximately increase to 0.80 (the delta) times $2.5 ($127.00 - $124.50) or $2.00.

The leap value then at expiration should be $40.00 + $2.00 or $42.00.(The same as our adjusted leap CB). If we then had to STC leaps to cover the cost of an ITM SC, you would not be selling below your cost and not lose money.

If the strike price calculated above has a delta of less than 0.25, choose a strike with a delta closest to 0.25. A strike with a delta much less than 0.25 does not, in general, produce adequate premiums. The delta also is an approximation of the probability of the option going ITM at expiration. That would be about 25% and if it goes ITM, you will have the ability to roll out or out and up for a net credit even if you have to select a month that is not the next near month.

STEP #7

This step is pretty much self-explanatory. In subsequent months, if the total SC premiums minus the estimated TV decay of our leaps during the duration of the SC is less than our monthly income goal, purchase additional leap contracts. The criteria will be the same as the original leap purchases. I keep those leaps as a separate new initial position to make accounting easier. I purchase enough leap contracts using the same steps as above to generate additional income to meet my monthly income goal.

I never exceed the amount of cash in the DLS cash account that has been allocated for new leap purchases as determined in Step #2 above.

STEP #8

EACH MONTH REPEAT STEPS #4 THROUGH $7

DISCLAIMER

Options involve risk and are not suitable for all investors. All investors who deal with options should read and understand the publication "Characteristics and Risks of Standardized Options." (www.cboe.com)

I do not promise, guarantee or imply verbally or in writing that anything contained in this paper will necessarily result in a profit. I am the copyright owner of all text and graphics contained in this paper and any spreadsheets. Copying, publishing or redistributing any material in any way without the written consent of me is strictly prohibited.

I am not liable for any losses or damages, monetary or other that may result from the application of information contained within this paper. Individual traders must do their own due diligence in analyzing options to determine if they represent a suitable opportunity. I am not responsible for any losses or profits that may result from the application of information contained within this paper. Option trading involves substantial risk. You can lose money trading options. There are inherent risks involved in the stock market and these risks should be considered prior to any decision.

Nothing published in this paper should be considered personalized investment advice. I am not licensed under securities laws to address your particular investment situation. No communication between us via email, chat room, or any other means of communication should be deemed as personalized investment advice.

ETF = EXCHANGE TRADED FUNDIV = IMPLIED VOLATILITYDLS = DIAGONAL LEAP SPREADSOTM = OUT OF THE MONEYATM = AT THE MONEYITM = IN THE MONEYDITM = DEEP IN THE MONEYSC = SHORT CALLLC = LONG CALLRO = ROLL OUTRU = ROLL UPBTO = BUY TO OPENBTC = BUY TO CLOSESTO = SELL TO OPENSTC = SELL TO CLOSENB = NOTE WELL