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Front-Loading Risk with Diagonal Spreads


Participate in the next leg of the bull market -- without losing your shirt.

A large block trade in the S&P 500 ETF (SPY) reveals what one investor expects for the market over the coming weeks. Chris McKhann has the details:

"In one trade of single blocks, executed all at the same time, an institutional trader sold 448,014 of SPY August 100 calls for 1.39, bought 298,676 of the October 106 calls for 1.37, and bought 149,338 of the September 103 calls for 1.51. All told, that is 896,028 contracts!

"This is a diagonal spread that will profit if the most is the SPY remains at 100 until expiration. But the trade is protected to the downside, and increased implied volatility will increase the profits to the downside. The trader may well be bullish, but not in the near term, and using this strategy to get into the long calls in a highly leveraged way."

This particular trade ended up being busted, but it's still worth analyzing. The thesis here is of the "short now, long later" variety: though I described this trade on Twitter as "big money calling a top," a more accurate characterization might well be that someone who missed out on this summer's rally is hoping to play catch-up.

The risk profile below should help clarify the way this trade would play out:

Click to enlarge

This diagonal spread is neutral-to-bearish over the next 7 days: The trade will be profitable if SPY is between roughly 96 and 101 at August expiration (the green line above), with the premium from the expired 100 calls offsetting some of the cost of the long calls.

Don't let the 3 legs cause confusion: The trade essentially shorts 2 front-month ATM calls in order to buy two out-month OTM calls. After August expiration, this becomes a straightforward long position (blue line), with limited downside risk but plenty of upside potential.

Of course, the trader might plan to sell additional calls in later months, but let's assume there will be no other modifications. Given that the calls don't start seeing significant gains until SPY is above 103, this trade might best be suited for someone who was very bullish and wanted to participate in the next leg of the new glorious bull market that is upon us, without risking much to do so.

This position essentially shifts the biggest risk into the front month by betting against a SPY breakout over the next week, which looks like a smart tactical play.
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No positions in stocks mentioned.

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