Taking Profit out of Diagonal Call Spread to Increase Leverage and Time to Expiry

Stock options are a leveraged trading vehicle for traders. There is a specific term that measures the level of the leverage. It is called Omega. Omega measures the relative percentage changes between the stock and the option, and is used as an elasticity measure for the option.  The formula to calculate Omega is given below.

Omega = Option Delta * (stock price / option price).

As the stock price rises, the value of the long call option increases. The Delta of the long call also increases up to a maximum value of 1 eventually. Once the Delta approaches 1, the most significant contributor to the option leverage level is the option price as it changes in larger percentages than the stock price, according to the above formula. Therefore, the leverage of a call option decreases as its stock prices rise to deep in-the-money (ITM). 

In a similar principle, the option leverage decreases for diagonal call spreads when the stock prices go further deep ITM while the short call strike remains out-of-the-money (OTM).  This is exactly what happened to my QQQ Diagonal Call Spread.

To keep sufficient option leverage, I rolled out the long call from July to September and reduced the Delta of the long call from 0.9 to approximately 0.65, which is my initial long Delta at the entry of my diagonal call spreads.  On Tuesday May 30th, I sold the original long call and bought a new call for a credit of $2.82.

The rolling adjustment to the diagonal call spread allowed me to take a profit of $2.82 and extend the life of my diagonal spread by more than 2 months. I can use the extended time to sell call options a few more times and receive additional premiums when needed to compensate for the option time decay.

The adjusted diagonal call spread also reduced its position Delta from 0.6 to 0.4. This was desirable for a stock that had risen consecutively in the last 7 days and I expected a pull-back soon. The pullback would cause less profit drops as the Delta was reduced. In the meantime, if the stock price continued to climb, the profit increase would be less as well. This scenario could be changed with the uncovering (buying back) of the short call though.

The QQQ diagonal entry and rolling history up to now is shown in the table and marked in the stock chart below.

Date	Spread	Side	Exp	Strike	Price	Net Price	Pos Effect	Total Cost
4/5/2017	SINGLE	BUY	21-Jul-17	130	5.86	5.86	TO OPEN	5.86
4/12/2017	SINGLE	SELL	5-May-17	133	0.8	0.8	TO OPEN	5.06
4/24/2017	DIAGONAL	SELL	19-May-17	136	0.58	-1.14	TO OPEN	4.48
		BUY	5-May-17	133	1.72	DEBIT	TO CLOSE	6.2
5/1/2017	SINGLE	BUY	19-May-17	136	1.86	1.86	TO CLOSE	8.06
5/17/2017	SINGLE	SELL	9-Jun-17	139	0.85	0.85	TO OPEN	7.21
5/25/2017	DIAGONAL	SELL	16-Jun-17	143	0.57	-2.05	TO OPEN	6.64
		BUY	9-Jun-17	139	2.62	DEBIT	TO CLOSE	9.26
5/30/2017	DIAGONAL	BUY	29-Sep-17	135	8.86	-2.91	TO OPEN	18.12
		SELL	21-Jul-17	130	11.77	CREDIT	TO CLOSE	6.35

In summary, the leverage of options is related to the strike price compared with the stock price:

• Deep ITM options have less leverage than ATM & OTM options
• ATM options have less leverage than OTM options and more leverage than ITM options
• OTM options have more leverage than ATM & OTM options

Increasing leverage usually means taking more risks for stock investments. However, this is not necessary true with the rolling diagonal spread trading strategy, as described in the example of this post. The main reasons are outlined below.

1. The rolling of the long option takes some profit out and leave less money on the table.
2. The rolling of the long option gives the position more time for selling additional premiums.
3. The rolling of the long option reduces overall position Delta and makes it less susceptible for stock price drops and smoother for profit gains.

The catch is that the new position will profit less before the long Delta approaches 1 again. This scenario happens with less probability though.