Microsoft as an example.

music selection:  “Vasoline” — Stone Temple Pilots

weigh-in:  196.6 +0.4

I’d like to write a diagonal call on Microsoft (MSFT). Recently volatility has me respecting a basic form of technical analysis. I want to see the price stay above the 200 day moving average for 5 trading days before I initiate a position. That test hasn’t been met so I’m going to “paper trade” this one to demonstrate how a diagonal call works.

Diagonal calls can be powerful as they generate an income stream on a deep in the money long dated call. You get upside price appreciation and get paid to wait. You want to use this strategy when you think a stock is cheap to fairly priced and is expected to slowly grind out a higher valuation over a period of a couple years as fundamentals improve in the underlying business. I think MSFT fits the bill. The primary business of providing operating system and office productivity software is mature and gushes predictable free cash flow. This protects us from the downside somewhat.The gaming and cloud services businesses are fast growing and high margin and can be expected to yield upward price movement.

The first thing you want in a diagonal call is a stock that fits the profile and also has LEAP options available. In this case, I will be paper trading the 50 strike 15JAN2021 call. To initiate the long call leg of the trade buy MSFT210115C00050000. It is enormously important to use a limit order and to be patient, sometimes for a week or more. The bid/ask spread is going to be very wide this far out and this deep in the money. A good price today might be around 52.75. Thus, you will have a cash outlay of 5,2750 plus commission.

The next step is to write (sell) a short call at a near expiry that is OUT of the money. The goal is to pick up some leveraged income without having shares subject to be called away. This would result in a temporary position of being short MSFT shares. I’m going to use MSFT190208C00112000 as an example. This call is 28 days out.  It is currently paying about 49 cents a share. The expected return on this trade looks like this: 49 cents / 52.75 cost basis / 28 days * 365 days = 12.11%.

You are out of the money but still earn a “good” return around 12% due to the leverage of only outlaying about half the normal amount of cash of a conventional covered call. You also have leveraged access to the upside (and downside!) of price movements in the underlying stock. It is also important to note the delta at the money is over 50% (better than half chance a normal covered call would see shares called away) while the delta at 112 is a little over 12%. There is a lot more certainty in this trade.

If the price gets too close for comfort prior to the expiry date or even moves into the money, roll the short call “up and out”. That is buy to close your short position and sell to open a new call at a later expiry with a higher strike price. It may be necessary to put more cash into the trade. In the unlikely event, you are assigned early, it is usually best to sell the long call and buy back the short shares to close the position. Your gain in the long calls will offset your loss on the short position in shares. Really, your counterparty did you a favor by surrendering the remaining time value on your short call.

I’ll be watching this position and some other diagonal call opportunities over the next couple weeks. I will document those trades here when and if they happen.