Take a look at the example of this trade in the risk graph below. This is a Ratio trade in that there are more longs than shorts. It is a Diagonal because the longs are bought at a higher strike price than the shorts, and it is a calendar because the expiration dates are different. The trader was bullish, long term, when it entered the position in March, put wanted to limit the losses to the downside, in case the stock did not climb as expected. By taking the credit for the July options, the trader is hoping to finance the longer-term options which is not a bad idea. As the July expiration approaches, the trader could roll over the short calls to a later month, thus collecting more premium. Hopefully, the stock would rally to $60, or at least act as a calendar, as the shorts expire worthless. If the stock continues to decline, the loss is limited to $50, but the loss will be reduced as the trader takes more premium.
First, what I don't like about the trade: AAPL has moved down strongly, and it could stay well below $40 as the expiration approaches. The rollover gains at that time could be quite minimal, because the differential between July and August $40 calls may be small, if they are both well OTM. I don't like that the trader elected to buy Jan 06, $60 calls. This was probably too ambitious when considering the choppy nature of the current markets. At the time the trade was entered, the average target price on AAPL was about $50 and the iPod was at the top of its popularity. I also do NOT like doing diagonals because the broker will consider this trade a credit spread and require more cash than originally apparent by the risk graph. OptionsXPress would probably say that the trade is a credit spread plus a call, and calculate the difference between 45 and 60 ($15) and multiply that by the number of contracts x 100 = $1500. In essence, you are committing $1500 or more to this trade, even though the risk graph in Platinum does not show it.
What I DO like about it is that if one is to be bullish on AAPL, this is a good way to take advantage of two common observations on AAPL trading: 1. AAPL tends to rally towards Christmas, and under perform in the April-August months. 2. The stock tends to spike in volatility close to earnings, which occur in April, July, October and November. In fact, shorting April calls could have been an excellent approach to this trade. Once the April options expired, traders would have turned their attention to the July options. July options have maintained their volatility level, precisely because of the earnings report, just before those July options expire. You could do a rollover to October, once the July earnings are reported.
Now, the important item in this trade: The volatility...
Do you see the spike in volatility for the short-term option represented here by the red curve? That spike corresponded to the April options until they expired, at which time the curve disappears. Since you entered your trade in March, if follows that you would have collected the volatility premium, even though the stock fell below $40 after expiration, and thus the option would have expired worthless. Selling the July options was also a good move, but selling the April calls, only one month before expiration would have been even better. Let's see:
If you follow this trade in Platinum, you will see that selling April options would have brought in more than 1/2 the cost of the long term call. Notice also that I sold ATM calls, which would not have been a bad idea since those options would have had the greatest I.V. The thing about AAPL is that expiration comes usually a day or two after earnings, so you have to be aware of that, because you MUST act to do the rollover early on the day after earnings, when the April options would have lost its volatility premium and pass it along to the July. In this case, the April options would have lost ALL its value, because the stock fell below $40 early in the morning. Yet the July Options would have brought in another $2.5 practically paying for all of the cost of the January options.
I would not be surprised if AAPL was to rally closer to $40 as earnings approach. However, I have been doing enough T.A. to know that anything can happen in such a long period of time. At this point, the maximum loss would occur if the stock was to rally slowly to $50 or so, never to make it pass our $55 target. Still, if the stock was to fall, the loss would be limited to the commissions, perhaps. Further, if you keep expiration and volatility in mind, you may actually do quite well. It is important to know the I.V. history of the stock. AAPL's management is quite secretive, hence the spikes before earnings. People just don't know what to expect.
Make sure that you talk to your broker and understand what the fees are for each transformation that you make along the way. Some brokers charge so much in commissions that it is hardly worth to make modifications at all. Each trade should be evaluated in light of the universe of opportunities available to you. Taking a timely small loss may be better than adding commissions to a losing trade. I don't recommend making modifications, unless the resulting trade is better than all others. Also, be sure that you understand the Volatility of the stock at or near earning's reports. Biotech stocks have additional considerations related to FDA approvals or news of breakthroughs. This trade is volatility intensive and you must understand that a loss in IV can cause a winning trade to become a loser. When doing rollovers, make sure that you understand the volatility of the options you are buying and selling. You want to SELL options with high volatility, and sell options with LOW volatility. Once the news are out, the volatility of the front month option will decline rapidly, making it a good time to cover the short. Options with future month expiration, particularly if they expire on an earnings month, tend to retain their volatility, and not lose value until AFTER the report. Based on that, the July options are still good. I would tend to keep them until after expiration, at which time I woud rollover to Oct.
This is an excellent approach to trading stocks you believe will continue to outperform the market. However, I am way too bearish to recommend any stock at all. It seems that these high fliers fall quickly out of favor, and this is where the PCRCC's excel. However, if I shared your optimism about AAPL, this is a good trade with relatively low risk. Here is the Platinum links for both trades:
OptionFox original trade:
http://platinum.optionetics.com/cgi-bin/platinumv30/op3email.php?trade_name=AAPL1™_date=2005-03-09&sym=AAQ&num_legs=2&tra0=-1:G05:45.000:2.600:AAPL:2005-03-09:48.25799942:FFFFFF:0:0&tra1=2:A06:60.000:1.550:AAPL:2005-03-09:42.49000168:FFFFFF:0:0
Juan's trade, modified to reflect volatility expectations:
http://platinum.optionetics.com/cgi-bin/platinumv30/op3email.php?trade_name=AAPL2™_date=2005-03-09&sym=AAQ&num_legs=4&tra0=1:D05:40.000:0.05:AAPL:2005-04-14:89.17600250:FFFFFF:0:0&tra1=-1:D05:40.000:2.650:AAPL:2005-03-09:57.94300079:FFFFFF:0:0&tra2=-1:G05:40.000:2.400:AAPL:2005-04-14:45.45100021:FFFFFF:0:0&tra3=2:A06:55.000:2.25:AAPL:2005-03-09:42.72600174:FFFFFF:0:0
One final word of advice to those Optionetics graduates... A cheap trade is not necessarily one in which you are expected to have unlimited gains while putting little of your money at risk. A credit spread may not be cheap because the brokers DO have cash requirements. Don't place a trade just because it seems like a good trade from a option's strategy stand point. It is far more critical that you are in a stock with the potential to reach your goal from a fundamental and technical analysis perspective. My horizon these days does not go beyond 3 or 4 months, and I prefer to take Vega and Theta profits rather than relying on Delta to do my work for me. That is just not easy in today's makets. These days, stock don't go up indefinetly like they did in the 90's. A good hedge is often not enough to prevent losses.
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