On 6/17/2010 I put on two diagonal spreads in ASML. (Click here to see the original post.)
Unfortunately, I put on the post right at the bottom price for the day. Subsequently, ASML moved up the next two days to a high of $31.41 and past our upside breakeven point. I didn’t like this large upside risk so I decided to limit it.
In order to limit upside risk I decided to buy some Jul calls. I choose to buy ten $32.50 calls for $0.45 and twenty five $35 calls for $0.10 (Total $700).
These cheap calls give me excellent protection in the face of a big rally. In hindsight, they would have been even cheaper had I bought them when I placed the initial trade, but I’m okay with spending money for good protection.
These long calls will allow me to exit the trade at my breakeven with a substantially smaller loss while still allowing me good profit to the downside, i.e. cheap insurance.
The new P&L chart looks like this: (click any picture to enlarge)
At the current IV, if I stop out at $32 I’ll lose around $800. Prior to buying the calls the same trade would lose $1,800. That’s good use of cheap insurance in my opinion.
Additional note: Although I am okay with losing the entire premium in my long calls for protection, as the market goes down my long calls will benefit from being long Vega. This will allow them to maintain some premium and I’ll take them off as I take off my diagonals and don’t need them for protection any more. Small amounts of money in question, but every little bit helps.
(This is not a trade recommendation, it’s for education only.)