Option Investor

Trade Alert - COP

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Time to "Roll On"...

Since Friday is the last session of the June options expiration period, readers in the Conocophillips (NYSE:COP) calendar spread should be rolling to July (call) options in the short portion of the position. The transition involves the purchase of JUN-$55 calls (COP-FK) and the sale of JUL-$55 (COP-GK) calls for a small credit; currently about $0.70 per contract. The cost basis in the long (AUG-$55) calls will be reduced by the amount received in the trade. Those who have a bullish outlook for the underlying issue might consider moving to a diagonal spread, which is a combination of a price and a time (calendar) spread.

For readers who are unfamiliar with this strategy, a diagonal spread generally involves the purchase of a long-term call and the sale of a short-term call at a higher strike price. In most cases, the initial debit of the position should be less than the spread between the two option series, removing the possibility of loss from extreme upside activity. The advantage of this technique is the cost basis of the long position is reduced by the sale of the short-term option and the spread achieves maximum profit (at expiration) if the stock price remains above the sold option's strike price. In addition, the spread can profit (before expiration) if the underlying issue advances significantly in a short period after the play is opened.

In trending markets, a diagonal position offers a noticeable improvement over the (vertical) price spread. If the underlying share value remains relatively unchanged or falls slightly, the long option will retain more value because of its extended maturity. If the near-term (sold) option expires, the position can be reestablished with the sale of a new option or, if the long option is current month, the position can be converted to a normal price spread. Once again, if the underlying issue rises above the sold (short) strike price, the spread will be profitable. With longer-term options, the character of the spread can be adjusted to match the outlook of the underlying issue. A neutral or bearish position can be established with the sale of at-the-money (ATM) options or the original spread can be duplicated (at a lower cost basis) with the sale of out-of-the-money (OTM) options. In either scenario, the diagonal spread can benefit - like a calendar spread - from the sale of additional options throughout the life of the (long) position.

Most of the advantages in a diagonal spread are obvious but there is one characteristic that most traders overlook. In a debit spread, if the stock advances substantially and the options trade at parity, the maximum potential profit will be limited to the difference between the strike prices. With a diagonal spread, the long option has more time-value premium. Thus, when the underlying issue trades near the strike price at expiration, the value of the spread will grow beyond the theoretical profit range. Because of that effect, the maximum potential gain (at expiration) occurs at the strike price of the sold option.

As we mentioned in the previous Blog, an understanding of relative value and implied volatility in option pricing is helpful to increase the probability of profit in combination strategies. When opening or adjusting any type of spread, it's important to take advantage of the highest relative premium to create the best possible position. The use of price disparities in spread construction is also paramount and traders should strive to initiate new positions when there is a disparity in the quoted prices that will result in a theoretical edge,

or discount, in the spread.

The great feature of options is they can be used in a number of ingenious ways to create the most appropriate position for the current market outlook and your personal risk-reward attitude. The right combination of puts and calls can produce an effective position with results that are similar to being long or short on the underlying stock (with less expense) and the premium from the sale of near-term options can be used to help pay for the spread. This approach also has the potential for unlimited gains over the long-term, thus providing an opportunity - one you don't have with vertical spreads - to overcome a number of losing plays. As with any trading strategy, it's important to thoroughly explore the various outcomes and potential risk, so you can comfortably execute the technique to its fullest potential.

The Dream is Gone...

Among the remaining (June) positions in the portfolio, there are no trades to be made - unless you have yet to close any short options that are "in-the-money." The new (July) spreads are also in good shape, however our recent adjustment in Dreamworks Animation (NYSE:DWA) is not performing as expected and given the lack of near-term upside potential for the stock, it may be best to simply close the position in the coming month and move on to more profitable plays. A similar situation exists in Estee Lauder (NYSE:EL), which will also end with a large debit, however the most disappointing aspect of both of these plays is they were profitable as originally offered. That condition seems prevalent throughout the MCM Portfolio during the two expiration cycles and a review of the recent candidates shows that positions in Legg Mason (NYSE:LM), Research in Motion (NASDAQ:RIMM), Toro (NYSE:TTC) and Sina Corporation (NASDAQ:SINA) would have expired profitably, had they not been closed (or adjusted) early to limit potential losses. With that fact in mind, we have decided to make some changes in the selection process for new spreads, as well as the position management techniques employed with each position. This initiative is long overdue and along with the addition of another staff member, we hope it will put the MCM Newsletter "back on track" with regard to earning consistent income for its many devoted readers.

MCM Staff

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