CALL DIAGONALS VS. SHORT PUTS: IRA BP EFFICIENT ACQUISITION
Typically, short puts have been the go-to methodology for acquiring shares at a lower price with the trade-off being that you don't take on the shares you want at the price you want, but keep the premium paid if the price of the underlying doesn't finish below your short put strike at expiry. That's not a bad thing, but what if (a) you want the ability to exercise for a lower price; and/or (b) want to undertake an acquisition strategy in a cash secured environment, like an IRA, where selling naked puts can be buying power intensive? Well, there is a setup for that -- the call diagonal.
Pictured here is a typical 90/30 call diagonal in SPY, with the 90 delta long as far out in time as you can presently go and the front month at around the 30 delta strike. I don't endorse this particular setup here at all-time-highs, so it isn't a live trade or recommendation, but rather a means to compare and contrast the relative buying power effect of short putting versus doing a call diagonal.
Although markets are wide for this setup in the off hours, making a precise pricing out of the trade momentarily elusive, it should price out with a break even at or below where the underlying is currently trading (298.46 as of Friday close). Consequently, it's safe to say that it should price out at spot (298.46) minus the long call strike (210) or 88.46 or even somewhat less. In other words, the buying power effect of the setup should be around $8850 per contract, give or take.
Solely for purposes of buying power efficiency comparison, let's look at what it would cost to put on the 210 short put in the same month as the 210 long call: it pays 6.30 in credit with a break even of 203.70. That will be the buying power that doing that in your IRA will tie up -- in other words, it'll tie up 203.70 in buying power ($20,370) versus the $8850 that the call diagonal will.
The other advantage to the call diagonal over the short put: the right to exercise the long call at any time, regardless of where the underlying is trading. With short puts, you don't have that right, so the only way you will acquire shares at the strike you want is if the underlying finishes below your short strike at expiry.
Naturally, as usual, there are a couple of potential disadvantages.
The call diagonal is a debit spread, so your max loss is known from the outset ( a very discernible advantage) and decreases over time as you roll the short call out for duration and credit, thus reducing your cost basis in the setup (another advantage). Nevertheless, it is conceivable that price can wind all the way down into your long call strike and then through it before you can reduce cost basis in the setup sufficiently to not lose money on it, all for the right to exercise the long call at a lower per share price and/or to tie up less buying power than you would short putting. Conversely, price could move substantially in your favor, making the right to exercise the long call at any time an advantage, particularly if the move is large.
In contrast, the price of the underlying can break the short put strike, and you can still make money on the setup, assuming that your break even isn't violated. Even then, you can roll the short put out for duration and credit, reducing your cost basis and therefore your break even further, all before taking on shares. By the same token, badly broken short puts can result in uncomfortable drawdowns with you taking a series of realized losses on rolls, even if you receive a credit for doing so, particularly if the move is protracted. Conversely, price could move in the setup's favor, but the max potential profit in a short put is that of the credit received, so you get diminishing returns as price moves away from the short put, delta decreases, and theta decay eats into extrinsic. You can naturally roll the short put toward current price to pick up additional credit, but if you wanted in at a particular price, doing that won't necessarily help you in that regard.
In a nutshell, call diagonals generally win over short puts in a cash secured environment for buying power efficiency, coupled with the right to exercise your long at any time if you're looking to get into the underlying at a particular price.
Pictured here is a typical 90/30 call diagonal in SPY, with the 90 delta long as far out in time as you can presently go and the front month at around the 30 delta strike. I don't endorse this particular setup here at all-time-highs, so it isn't a live trade or recommendation, but rather a means to compare and contrast the relative buying power effect of short putting versus doing a call diagonal.
Although markets are wide for this setup in the off hours, making a precise pricing out of the trade momentarily elusive, it should price out with a break even at or below where the underlying is currently trading (298.46 as of Friday close). Consequently, it's safe to say that it should price out at spot (298.46) minus the long call strike (210) or 88.46 or even somewhat less. In other words, the buying power effect of the setup should be around $8850 per contract, give or take.
Solely for purposes of buying power efficiency comparison, let's look at what it would cost to put on the 210 short put in the same month as the 210 long call: it pays 6.30 in credit with a break even of 203.70. That will be the buying power that doing that in your IRA will tie up -- in other words, it'll tie up 203.70 in buying power ($20,370) versus the $8850 that the call diagonal will.
The other advantage to the call diagonal over the short put: the right to exercise the long call at any time, regardless of where the underlying is trading. With short puts, you don't have that right, so the only way you will acquire shares at the strike you want is if the underlying finishes below your short strike at expiry.
Naturally, as usual, there are a couple of potential disadvantages.
The call diagonal is a debit spread, so your max loss is known from the outset ( a very discernible advantage) and decreases over time as you roll the short call out for duration and credit, thus reducing your cost basis in the setup (another advantage). Nevertheless, it is conceivable that price can wind all the way down into your long call strike and then through it before you can reduce cost basis in the setup sufficiently to not lose money on it, all for the right to exercise the long call at a lower per share price and/or to tie up less buying power than you would short putting. Conversely, price could move substantially in your favor, making the right to exercise the long call at any time an advantage, particularly if the move is large.
In contrast, the price of the underlying can break the short put strike, and you can still make money on the setup, assuming that your break even isn't violated. Even then, you can roll the short put out for duration and credit, reducing your cost basis and therefore your break even further, all before taking on shares. By the same token, badly broken short puts can result in uncomfortable drawdowns with you taking a series of realized losses on rolls, even if you receive a credit for doing so, particularly if the move is protracted. Conversely, price could move in the setup's favor, but the max potential profit in a short put is that of the credit received, so you get diminishing returns as price moves away from the short put, delta decreases, and theta decay eats into extrinsic. You can naturally roll the short put toward current price to pick up additional credit, but if you wanted in at a particular price, doing that won't necessarily help you in that regard.
In a nutshell, call diagonals generally win over short puts in a cash secured environment for buying power efficiency, coupled with the right to exercise your long at any time if you're looking to get into the underlying at a particular price.
Comment:
I would note that it is simple to make short put selling in a cash secured environment far more BP efficient than going full on naked (trust me, no one wants to see me full on naked). Buy the Dec '21 95 put for .27 and the BP of the resulting spread (the 95/210 short put vertical) decreases from the aforementioned 20.4k to 10.9k or so. Paying .27 to bring in BP by 9.5k or nearly 50%.