Today I bought a diagonal call spread on Wal-Mart (WMT), which consisted of purchasing six January 2011 $50s, and selling six April $55s for a net debit of $3,030, plus commissions. Pending sharp price movement this will be a campaign-style rolling spread. As the April calls near expiration, I'll roll out a few months and so on and so on.
This position is very much a synthetic covered call that utilizes non-recourse leverage. I pay a time value premium on the in-the-money long options ($1.515 per share as of the close) which essentially represents a borrowing cost for the non-recourse leverage (3% for 11 months, or $1.515/50 - the time value premium over the strike price). At the same time I am selling calls which represent a higher annual premium (.8% for about a month and a half (or about 6.5% annualized) while also maintaining some delta exposure (at least initially). Note that for simplicity's sake this analysis ignores the dividend payment.
The position has very little ultimate upside risk (the most the position could lose on the upside is $5 per spread (they are priced at $5.05 each), but has solid delta exposure because the long option maintains much more delta initially (the difference would decrease as the stock rose in price). If WMT increases substantially, I'll likely sell for a modest gain. Ideally, WMT will stay relatively flat for an extended period of time. I think this is likely given WMT's stability, reasonable valuation and dividend yield. Ultimately, however, I think Wal-Mart will gradually ascend upwards given its steady growth and cash flow. If the stock declines a reasonable amount, I may add additional upside exposure by purchasing an out of the money January 2011 or 2012 call or two. At this point, I'm happy with the additional downside protection given the markets year long bull run.
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