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In a recent report, we examined an option strategy known as the backspread. This week, we examine a related strategy, the diagonal backspread. As we shall see, each type of type of spread has its own risk/reward characteristics, which can make them attractive under different sets of circumstances.

Backspread Review

With the standard backspread, the investor buys a number of options at a one strike price and then sells a lesser number of options of the same maturity that are struck more deeply in-the-money. (You may want to refer to "Finding and Setting Backspreads," Ot00612.Pdf in our Options Reports Archive).

If you set it up properly, a backspread can give you unlimited profits if the stock's movement favors the bias of your long options (i.e. up for calls and down for puts). If time premiums are low enough, there is often a chance that you can establish a backspread at a net credit of premium. Often, for short time periods, backspreads can be almost "risk free" (not counting bid/ask spreads and commissions).

However, as we stressed in our recent report, backspreads do have risks of their own. With a backspread, your worst outcome is having the stock end up at your purchased options' strike price. When this happens, you lose all the premium of these long options. You are also likely to have a loss on the short option component as well.

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In general, backspread opportunities exist in low volatility, low time premium markets, in which you can establish these spreads at very little cost - or even at a net credit. Usually, you want to hold a backspread only about halfway to its expiration. You do this so as to minimize the effects of the accelerating time decay of the purchased options.

Why a Diagonal Backspread?

With the "diagonal backspread," you buy longer-term options and sell a lesser number of nearer-term options that are more in-the-money. Diagonal backspread opportunities often exist in volatile, relatively high premium markets, such as we have been experiencing. With the call diagonal backspread, you can take advantage of the fact that in nervous markets, the nearer-term lower-strike options become steeply overpriced, while the longer-term higher-strike options tend to remain fairly priced.

An Example with the SPY

In Figure 1 above, we show an example of a diagonal call backspread. On July 17, 2006, with the stock S&P 500 at 1,235.20 and the S&P 500 ETF (SPY) at $123.52, we bought 3 SPY December $126.00 strike calls at $4.90 per share and wrote one shorter-term August $110.00 strike call at $14.20.

Notice that in this spread, we got a price advantage both on the calls we purchased and on the call that we wrote. We paid $1,470 for our three long calls, which is less than our model's Estimate of $1,556, and we received $1,420 for our written call, which is more then our model's estimate of $1,392. On a net basis, we paid a premium of only $50, less then our model's net estimate of $163.

Looking at Graph 1 below, notice that if the stock stays at $123.52, the net loss to the position on the August expiration is likely to be only $176. (Here we are assuming that the implied volatility of our longer-dated calls does not drop.) On the upside, as the long calls move into the money, the gains are unlimited. On the downside, our maximum loss is likely to be no greater than around $50 (again assuming the implied volatility of the long calls stays the same).

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A Question of Probabilities

The reason why this favorable spreading opportunity exists is that the market is assuming that there is a only a 76% probability that the SPY will end up above $110.00 on the August 19th expiration date, while our own estimate of this probability is around 81.0%. You can find these probability estimates in our Detailed Option Profiles, in our Options Screener and in our downloaded spreadsheet data (columns AN, AO and AP). Our estimates are based on our Adjusted Volatility Forecasts for these particular options, while the market's expectations are derived from the options' implied volatilities.

Testing this Out

Because there is little overall time decay, diagonal backspreads can offer a very efficient use of capital. As with their backspread cousins, you should always test a diagonal spread beforehand, and carefully monitor it after you have established the spread. To do this, we recommend that you use our template Whatifi.Xls, which you will find in the Options Templates section of the online Archive.