The downside of the hedge is the possibility of a surprise big surge of the stock price soon. It will cause the trade to gain less value than the original naked call position, since the short call option will cost more to be bought back. This is the cost of the hedge in this option strategy.
Today, the price of MU on which I have a naked long call position (Oct 20, $27 Call) expressed the first signs of its weakness. A few days ago, I bought the MU call option as MU broke out of a bullish flag chart pattern as posted in An Analysis of 3 Bullish Stock Chart Patterns. About 5 trading days later, MU had two days of price drops in a roll and looked going down today as well. Its MACD histogram also declined 2 days consecutively as shown in the chart below. These are the specified signals for me to hedge with short call option for such a position. As a semiconductor company, it also showed weaker relative performance against the SMH semiconductor ETF.
Therefore, I sold June 9 $30.5 call for a credit of $0.34 to leg into a diagonal call spread position on MU. As usual, I chose the option Delta to be greater or equal to 0.25. The OTM call Delta is the roughly the same as the probability of this option strike to expire ITM. So there is approximately 25% probability that MU will expire above $30.5 at this point. The new cost of the trade is reduced to $4.21 - $0.34 = $3.87.
As always, we need an action plan for the future in case the stock prices reverse its current course. If MU ends its short term pull-back and starts to rise strongly for at least one day, it means the stock is back to its up-trending pattern. Then, I’ll buy back the short call option. This is what I had done for EEM as posted in EEM Diagonal call spread adjustment as emerging market outperforms. Otherwise, if the prices grind upward and the Delta reaches over 0.60, I'll roll out the short call.
There are many helpful free introductions to the basic concepts of diagonal call spreads. The one that I found with relatively complete descriptions on the characteristics of this strategy is at TheOptionsGuide.com: Diagonal Bull Call Spread. It explains the following aspecs of the diagonal call spread:
- Spread construction
- Profit potential
- Downside Risk
- Theoretical Example
- Similar Strategies