Options for Rookies

Iron Condors vs. Credit Spreads

Hi Mark,

I've been buying spreads recently instead of iron condors since I fancy myself to be a market prognosticator.

I want to be certain that you know this, although I suspect you do.  Whether you buy a spread or sell a spread with the same strikes (puts vs. calls), it's the same play with the same risk and reward.

Example:  Buying IBM 120/130 call spread is equivalent to selling IBM 120/130 put spread (same expiration).

Thus, whether you buy the call spread, or sell the put spread, it's the same bullish play.

The difference between your spread (or it's equivalent) and the iron condor is that the latter involves selling both a call spread and a put spread.

That strategy worked for my Jan bull put spread but my Feb bear call spread in RUT is starting to get a little too close for comfort...hopefully I won't have to ask you for exit strategies in a few days. 

Once again, I want to mention a pet peeve of mine.  The term 'bull put spread' is unpalatable to me.  I prefer 'sold the Jan put spread.'

If the Feb call spread that you sold is making you nervous, there's not much to an exit strategy.  You just exit at the proper time.  I assume you are referring to adjustments.  Much depends on how far OTM your call spread is when you decide to act.  There are usually good alternatives.

Anyway, I wanted to ask if my supposition is correct: that the risk is the same for spreads and iron condors with equal deltas. ie: a spread with a 15 delta and an iron condor with a 15 delta will both expire ITM roughly 15% of the time. Somehow I think it's not that simple since it seems the premium collected has been larger for spreads than iron condors of equal deltas.

Right you are.  It's not that simple.

I'll assume you are referring to the same underlying asset, or at least ones with very similar implied volatility.  It depends on what you mean by a 15 delta iron condor. 

If the call spread portion of the IC and the put spread each have a 15 delta, then the IC finishes ITM 30% of the time.

If the sum of the deltas is 15, then yes, one or the other finishes in the money 15% of the time.

The premium for an IC should be double that of a single credit spread, when the call spread and the put spread are each 15 delta.  Double the premium; double the risk.

As an aside, I was wondering what your opinion is on the current market volatility? It seems the only index worth trading currently is RUT, but with earnings coming up this month I presume volatility will only go upwards from here.

I truly don't look at the other indexes, seeking better trading opportunities.  I lack the time, being far too busy writing.

My opinion is that I don't know in which direction IV is more likely to go.  Higher would be my choice if I had to wager, but as recently as Jan 2007, VIX was under 10.  I don't believe earnings season will play much of a role - unless there are many earnings surprises.

If you want to have positions that do better when IV expands, consider single or double diagonal spreads.  They are long vega and both iron condors and credit spreads are short vega.

571

Q&A. Iron Condors, Double Diagonals and Impled Volatility

More questions from Don:

With IV [implied volatility] and the pricing of IC [iron condors] and DD [double diagonals], you mentioned that trading IC works better when IV is high and that DD are better when IV is low...but those are relative...yes the IV affects the price, but it affects ALL four components relative to each other so that their relative profitability towards each other is the same?

Same with DD's but it may be different because of the calender component. Doesn't IV affect the front month more than the back month?

***

For my comfort zone I prefer to trade iron condors when IV is elevated.  When I believe (obviously I cannot be certain) IV is at the lower end of its range, I prefer to trade double diagonal spreads.

This concept is explained in The Rookie's Guide to Options.

For those unfamiliar with the strategies, the iron condor is constructed by selling a call spread and a put spread in the same underlying asset and for the same expiration.

The double diagonal is similar to the iron condor, except the options you buy still have the same strike price, but they expire one month later.

1) The major reason that my strategy selection depends on IV is based on the nature of these positions.  When you own the double diagonal, you effectively own the iron condor plus two calendar spreads.

When IV increases, the value of a calendar spread increases.  That's another way of saying that DD spreads have positive vega.  Positions with positive vega do well when IV increases.

Thus, I buy these positive vega positions when IV is low and  the chances are good that IV will be higher (than it is now) when the front-month options are about to expire.  If IV has increased, I will get a good price when I exit the position and sell my longer-term options.  If IV has declined, I will be forced to exit my position at less favorable prices.

Iron condors have negative vega and do well when IV decreases.  If that IV decrease is significant, it's often possible to exit the trade with a quick, but good-sized profit.  Because these spreads do well in a falling IV environment, I prefer to own them when I believe IV is high and likely to fall.

It's not complicated.

If any iron condor trader wants to own a portfolio that has very limited volatility risk, it's a simple matter to add some double diagonals to the position mix - enough to turn the portfolio vega neutral.

2) Your point about the option prices moving in tandem is not accurate.  When you are selling OTM call and put spreads, those spreads widen as IV increases because the options which you sell have more vega than options you purchase.  That's why the spread has negative vega and it's the reason that higher IV means you can get a higher premium when you sell these put and call spreads.

3) It is true that a rising IV environment usually imparts a larger percentage increase in the IV of the front-month options.  But you do not trade percentages; you trade dollars.  Longer-term options have more vega than their front-month counterparts.  Thus, even though the IV increases by a smaller percentage, it increases by more dollars.  In other words, the premium increases more for the long-term option than the short-term option.  That's why calendar spreads widen (become more profitable) as IV increases.

***

I have difficulty reconciling "buying a spread" netting me money and "selling a spread" costing me money so I have just used trading a spread for ease of use.

***

When you buy an iron condor you sell the call spread and the put spread.  That means you are buying the iron condor and collecting a credit.

There is no official nomenclature for the options world, and to me, that's a shame.  Many people feel as you do and use the term 'sell' an iron condor when I would say 'buy' the iron condor.

There is a rationale for this, but it's lengthy.  In summary, when you buy a condor spread, you profit when the stock remains between the strikes.  The 'iron' variety of the condor should profit under the same circumstances.  Thus, logic tells me that if I'm buying the condor, hoping the stock remains within a price range, then I'm also buying the iron condor when I also want the stock to be range-bound.

One further point.  Suppose you want to trade a diagonal spread - for example the XYZ Dec 100/Nov 95 call spread.  Your goal is to own the Dec call and sell the Nov call, and you tell the broker to buy the spread and pay a 10 cent debit.

When your broker comes back and reports that you 'bought' the spread at your price, a 10 cent debit, and that you own the NOVEMBER call and sold the DECEMBER call, you will be very disappointed.

What do you do if his explanation is this:  You said 'buy' the spread, so I bought the higher priced option (NOV) and sold the lower priced option (DEC).  How can you complain?  Doesn't that fit your description of buying the spread?  You bought whichever option was higher priced and therefore paid a debit.

That's why 'pay a debit' is insufficient to distinguish between buy and sell orders.  At least in my opinion.

there's still more from Don...

482

I Get Stacks and Stacks of Questions. Dear Mark...

Letters, we get letters, we get stacks an' stacks of letters . . .
Dear Perry . . .Would you be so kind, to fill a request, and sing the song I like best?

***

Mark

I have some questions for you on managing risk and complementing IC positions with double diagonals. In your opinion is it smart for an IC buyer to also trade some double diagonals to offset vega risk? I am just getting the hang of IC trading and I don't want to over complicate things, but I thought I would ask the question and learn more about DD's.

Right now I am continuing with my weekly purchase of IC strategy. I am buying 2 contracts of a RUT IC for the 3rd month (SEP right now) roughly once a week. I choose short strikes with a delta of 10 and try to get $1.80 per IC. Right now I have a few put spreads (6 contracts) left from my August IC positions and have GTC orders on these offering 0.30 each. I also own 6 Sep IC's. For insurance I currently own one July 420 Put and one July 580 call. My risk curve is fine right now but once July expiration comes, I will lose the protection. At that point my current plan is to buy one Aug Put and one Aug Call (I don't want to pay for more protection right now, as the July Call and Put are still working. Does this make sense to you?). At the same time (after July expiration) I will switch to buying the October IC's each week, and put in GTC orders to close my September spreads offering 0.30 each (This is my autopilot early close plan that I really like. Of course if my short strikes are threatened or if time left gets below 3 weeks I will proactively close at higher prices).

What do you think about my risk management approach? Any suggestions to improve it? Will adding a weekly DD purchase allow me to avoid buying the call and put? I very new to trading IC's so I like the idea of keeping it simple. But I also wonder if there is a way to get better protection at a lower cost.

What do you think of my strategy as a whole? For getting $1.80 to start I realize I give up a lot of this to buy back the spreads and for protection. The math I did tells me that after paying to buy back the spreads at 0.30, paying for insurance puts & calls and paying for commissions I am left with a profit about $0.70 - and that is assuming that everything goes well and I don't have to adjust.

As an aside, I was intrigued by your latest video post where you mentioned you sold July put spreads with only two weeks left. I thought about doing the same thing a couple of weeks ago on the call side because my risk curve was so positive on the upside (when all my Aug Call spreads had closed automatically for 0.30). However I decided against it as I told myself I am still learning and didn't want the added complications of near terms options. Right now my game plan is "close any short spreads when there is less than 3 weeks left" (My gut tells me that as a beginner this is prudent).

I look forward to hearing your thoughts, and suggestions. My apologies for the long post. If you prefer that I break it up on multiple posts I can do that.

Rgds

TR

***

Hello TR,

1) I have mentioned the advisability of combining iron condors with double diagonals to minimize vega risk.  Where have you been, oh trusted reader?

My advice is to offset all or part of the vega risk when you believe vega is reasonably priced.  Own IC  (short vega)when you believe  IV is high (and not going much higher) and own DD (long vega) when IV is low (and you suspect it's not going lower).  If you don't want to express an opinion, then it's always okay to own a combination of positions and remain near vega neutral.

2) If you get $0.90 per side for an IC, don't you find that $0.30 is too much to pay when exiting?  It's fine when two months remain before expiration, but is 30 cents comfortable for you when closing Aug spreads?  This is a question, not a criticism.   It seems to me that giving up 1/3 of the premium and buying insurance and selling low-priced spreads is a tough road to profitability.  More below.

3) Yes, your insurance program makes sense.  But you have overlooked one aspect that requires a decision on your part.  You own the July 420 put.  If the market turns south and RUT is near 440 when expiration arrives, you will own no insurance and replacing it will be costly.

Yes, it feels right to postpone buying Aug insurance options because theta will make them less costly when you buy them later.   And you already own insurance.  But, per the scenario I suggested in #3, waiting may turn out to be a costly decision.

Here's a compromise.  Consider trading 4 IC this week - collecting extra cash and use that cash to buy  a one-lot of Aug insurance.  Note the verb I used is 'consider.'  This may not feel right for you. 

4) The questions you must answer in your methodology:

a) How often will you earn that $0.70?

b) When you don't earn 70 cents, what do you anticipate your average loss will be - if you have the time to exit the trade at your convenience (i.e., not in a panic)?

c) How frequently (obviously an estimate) will you be taking that loss?

d) How much will you lose, and how often, in your worst case scenario.  Perhaps there's a gap opening or perhaps you get stubborn?

e) Combining the above calculations, how much do you expect to earn in an average year?

f) Does the reward justify the risk?

That's your bottom line.  It doesn't matter what I think of your methods.  What do you think of them?  Is 70 cents going to do it for you?  This is like any business - you must have a business plan.  Can you survive on your numbers?  If 'yes,' go for it.  If 'no' where are you going to get that extra income?

5) Do you believe that 'better protection' is available at a lower cost?  That's not generally the way insurance works.

You should want insurance that works for your positions.  The truth is I don't know what that should be.  Owning extra options is 'best' when a very large market move occurs.  But it doesn't help much if there is an IV expansion that occurs without a large move.  I may be wrong, but my belief is that you do the best you can protect yourself.  But sometimes you'll just own the wrong protection and there's nothing you can do about it.  By wrong protection I mean you lose the cost of insurance and your portfolio also loses.

6) Adding some DD positions merely provides limited insurance against an IV explosion.  If the market moves too far, these embedded calendar spreads (DD = IC + calendar) will fail to serve their purpose. [Calendar spreads lose when both options move far into the money.]

7) Regarding my sale of July (front-month) put spreads: I clearly explained that I was selling some of those ONLY because I had just bought in a much larger quantity of July spreads.  I also went out of my way to mention that I had plenty of room - riskwise - to make those sales. 

I closed the same put spread the previous day.  So for example, if I covered 10 IC and decided to sell four put spreads, I obviously can afford that risk (or otherwise I would not have been able to hold the original 10-lot).  Please don't take this the wrong way, but details matter and you should not take sentences out of context.

8) Selling near-term put spreads would not be the same for you - simply because you had not just 'made room' to trade those spreads.  Yes, prudence is intelligent at all times.

380

Trading Double Diagonal Spreads; Part II

Part I

Double diagonal (DD) spreads provide profit opportunities that are not available to iron condor (IC) traders.  But, from the point of view that it's possible to lose more money per spread with a DD than with an IC, they can be riskier investment choices.  One immediate disadvantage is they they have higher margin requirements.  While reasonable brokers have identical margin requirements for an iron condor as they do for either of the spreads that makes up that IC (no additional margin to sell a put spread when already short a call spread). That's not true with diagonal spreads.  A double diagonal has twice the requirement as a single diagonal.  That makes no sense to me, but I have no influence over brokers and their rules.

The margin requirement for a diagonal is the difference between the strike prices, less the credit collected (if any), per diagonal. 

Trading RUT iron condors, I choose strike prices that are 10-points apart.  These simply feel comfortable to manage than when the strikes are near each other - but that's a personal comfort zone decision, and not a recommendation.

When trading diagonal or DD spreads, I use strikes that are farther apart.  I confess that this is not based on a sound, mathematical rationale.  It's based on the fact that I prefer to own a diagonal spread that provides a cash credit, or a small debit.  Because of the pricing of RUT options, most of the time I own a diagonal spread in which the strike price of my month 2 long is 30 points away from the strike price of my month1 short.   Occasionally I buy the position when the strikes are only 20 points apart and find these 20-pointers to be easier to manage.

If RUT marches strongly through the short strike, the maximum loss can approach $3,000 per spread (less any time premium remaining in the long option).

I look at it this way (referring to just the call spread, although this point applies equally well for the put spread):  If I have a position similar to: 

 Short 10 GOOG Sep 470 calls

Long 10 GOOG Oct 480 calls

the position is not going to do well on a quick upside move through 470.  Thus, there's upside risk.  If I pay a big debit to open this position - say $500 - then there is also downside risk.  If GOOG drops too far, especially if a few weeks have passed, both options may quickly move towards zero and most of that debit can be lost.  Thus, I trade these spreads to avoid the chance of losing in both directions. [Yes, if it's a double diagonal, the downside move threatens the put spread, but at least it will not also hurt the call spread.]

 

DD Opportunities Absent from IC

To offset that extra risk, there are profit opportunities not possible with iron condor positions.

1. If the stock moves toward one of the strike prices - and especially if some time has passed, instead of facing a loss as the iron condor trader would be facing, there's a good chance that the diagonal spread could be closed profitably.  Whether that comes to pass is going to depend on how much time remains before the front-month option expires, and the current implied volatility of the calls you own.

2. If closing doesn't appeal, and you prefer to hold this position, selling the calendar spread when it is nicely priced (the stock trading near the strike price increases the value of a calendar spread) allows you to take cash out of the trade.  In the GOOG example, you sell your GOOG Oct 480 calls and replace them with Sep 480 calls.  That's selling changes the position from a DD to a combination spread.  It's half an iron condor on the call side and remains a diagonal on the put side.

If the position soon becomes risky to hold, you can use some of that newly- collected cash to pay for an adjustment.  Alternatively, you may elect to exit.

3. If enough time passes and if the underlying moves far enough away from one of the strike prices, you may be given the opportunity to repurchase one of the options you sold at a very low price.  Looking at that GOOG spread again, if the GOOG SEP 470 calls are available, you may decide to cover them by paying $0.20.

When you do that you have two good choices.  The first is to sell the Oct 480 calls, closing half the DD and probably earning a decent profit.  The second choice is to sell the Oct 470 call spread, converting the call portion into half of an October iron condor.

Deciding which is better is going to depend on the price you can collect for the Oct 470 call and how attractive it looks to own that specific GOOG Oct call spread.  Do not make this trade unless you want to own the position.  There's nothing wrong with exiting the trade.

The possibility  described above was discussed in the comments to Part I.

4) If IV explodes higher and if your underlying has not moved so far that your position is endangered, you can collect on that IV surge by selling two calendar spreads and converting the DD (which you want to own when IV is low) into an iron condor (which you prefer when IV is high - because it's too costly to buy the vega-rich DD spreads).  Of course, if it's attractive to do so, you may choose to exit the DD instead, and pocket the profit.

The new IC may run into trouble in the volatile market, but selling the two calendar spreads allowed you you own this position at a very favorable price.

Double diagonal spreads are more flexible than iron condors, but they are rich in vega and you want to own them only when you believe IV will be increasing - or at least not decreasing.  If IV feels too low to be trading iron condors, you may decide to compromise and own both iron condors and DD spreads.  Or you can open the combo spreads: Half an iron condor on the call side and a DD on the put side [or vice versa, but a downward move which hurts the put side of the IC may not be hurt as badly when you own the extra vega that comes with the diagonal].

367

Trading Double Diagonal Spreads. Part I

Hat tip to jcvictory for suggesting this discussion.

Double diagonal spreads and iron condors are cousins.  The relationship is not one of 'blood,' but they are related through the marriage of iron condors with calendar spreads.

If you are not familiar with these option strategies, use the above links for an introduction to each.

When trading IC the trader usually has a good method in place for deciding when to exit a profitable position.  He/she may have a specific price that is willingly paid, and that price may vary with the number of days remaining before the options expire.

The plan may be to hold through expiration.

Some traders buy in the position when a specific percentage of the maximum profit has been earned (roughly 80+%).  That's similar to the first method, but the price paid is a function of the original premium collected, and not time remaining.

I've discussed adjusting an iron condor trades gone awry many times and offered several risk-reducing (this link is to one idea) approaches for you to consider.  Today I'll discuss happier times - profitable times.

When trading diagonal spreads (or double diagonals), the 'close for a profit' decision is much more complex.  Why?  When the iron condor has reached a price of $0.15, there's only that $0.15 left to be made.  There's not too much to be earned from holding and each trader can decide whether holding or closing is best.  It's not a big deal, although I am a big fan of closing early because there is so little to gain and so much to lose.

When trading the diagonal, the major difference is that you are short the front-month option and own an option with a more distant expiration date - most often one month later.  Thus, as your short option moves towards zero, you don't want to hold 'too long' because the value of your long option must be protected.  The cash you collect when selling your long options plays a huge role in determining the overall profitability of the diagonal spread (single or double).

Time decay is generally positive (profitable) for the diagonal spread owner, but there is some compromise point at which it's no longer a good idea to own the position because the time decay collected by remaining short the front month option is readily offset by several factors:

Time decay of the long option: At some point your long begins to decay as rapidly as your short.

Vega risk:  If IV is declining, as it has been in recent times, then the longer you own the position, the less you can collect when selling your longs. Holding longer is a wager that IV will soon increase.

Delta risk: If the underlying stock or index moves so that your options are farther out of the money (we are only discussing one half of the double diagonal spreads; not both sides simultaneously), as soon as the delta of your long exceeds the delta of your short, your spread declines in value - and a portion (all?) of your profits can disappear.  When looking at a call spread, it's bad enough to lose money when the stock surges through the strike price of your short options, but you don't want to see your profits disappear when the stock declines. At some point, it a good idea to close the trade and keep what you have earned.  Remember, profits that are in your account today represent your money.

The objective is to exit the trade when you can still collect enough from your long option to provide a decent profit. This is not a consideration when trading iron condors (because your long is always worth less than your short). I can suggest no cast-in-stone rules to guide you.  As with many decisions that must be made when trading options, your comfort zone limitations and profit requirements can best be determined by the individual investor.

Next time I'll take a closer look at some items to think about when it's time to take the money.

to be continued...

362

Iron Condors: Reduce Volatility Risk

For the individual investor who is trading options without taking the time to learn many of the finer points of options theory, the major risk for the owner of an iron condor position is that the underlying stock or index will be too volatile, or even worse, be uni-directionally volatile (several big moves, all up or all down) resulting in one of the options sold moving (or threatening to move) into the money.

The iron condor is a position in which one call spread and one put spread are sold: same underlying, same expiration date.  Profits are earned when time passes and you can buy both spreads for less than you collected when you sold them.


What can be done to reduce risk?

1) To reduce or eliminate the loss that results when the stock moves too far, you can buy extra puts and calls (strangles).  I've already covered this idea more than once.  Naked long options go a long way towards offsetting losses (and sometimes can turn the entire position profitable) - when you own the right strike prices.

2) Certain risk characteristics of options are described by Greek letters, and are collectively known as 'the greeks.'  Trading and keeping things simple is acceptable, but it's not a good idea to trade options by ignoring your exposure to risk.  Four of these risk factors are worth your time to understand: delta, gamma, theta, vega.

The numbered statements below assume a 'normal' iron condor.  That means that the underlying has not moved so far that prudence would have convinced you to exit the trade.

3) Iron condor positions always have positive theta.  That means the theoretical value of the position increases every day.  Theta is your friend.

4) Gamma is negative.  Because gamma measures the rate at which delta changes, that negative gamma is your enemy.  It makes you longer in a falling market and shorter in a rising market.

5) Delta is a measure of how 'long' or 'short' the position is.  When delta is -30, you can expect to lose $30 for the first point that the underlying moves higher.  Because of negative gamma, the next, and each subsequent one point move, results is slightly larger losses.  Similarly, you earn that $30 when the underlying makes a favorable move (down is favorable when you have negative delta).  But each subsequent one point move earns less and less (negative gamma reduces positive deltas quickly), until delta turns positive.  Then you begin to lose money as the underlying declines.

Thus, it's important to pay attention to delta and not allow it to reach an uncomfortable level.  I cannot define that level for you.  At some point, I recommend that you consider making a Stage I adjustment.  And then a Stage II adjustment, if necessary.  If the market continues to move against you, at some point (Stage III or IV), it's time to concede defeat on this spread and take the loss.  Why?  To be certain you incur no large losses.  If you avoid big hits, you will make money with iron condors.

6) Vega is always negative for an iron condor position, and that means volatility risk.  When implied volatility increases, the iron condor trades at higher prices, resulting in a loss. 

But this is one risk you don't have to take.  There are methods for making these positions vega neutral, or at least, less vega negative.

One such idea is to buy calendar spreads.  These spreads have positive vega.  You have a couple of reasonable choices:

a) Instead of opening iron condor positions, open some double diagonal spreads (combination of iron condor + calendar) and some iron condors.  Choose an appropriate number of each to make the combination vega neutral.

b) Choose a different calendar spread, but choose strike prices that are in an area where the iron condors will be losing money.  Calendar profits can offset some of those losses (that happens when the calendar strike price becomes an ATM option).

319

Diagonal Back Spread. Follow-up II

The market has moved much higher since the (hypothetical) diagonal back spread was opened (March 27, 2009).  At that time, RUT was trading near 429.  Today, when I took a snapshot for analysis, the index is 489.5.  That's an advance of more than 14%.

But 33 days have passed and IV has decreased.  How has the position performed? 

The rally was beneficial, due to positive gamma.  But the IV decrease played a negative role also (compare values in column headed: Imp. Vol.). 

Most of the time value has disappeared from the May options (460s), and that's good, but the passage of time has hurt our long positions (Jun 500, 510, or 520 calls).

Let's see where the positions stand.

 
Estimating that we would have to pay $36.90 to buy May 460 calls, the cost to close is: $36,900

When exiting our long calls, we'd be able to collect:

A. Sell 16 Jun 500 calls @$25.40, collect $40,640.  Credit for closing the spread: $3,740. 

B. Sell 19 Jun 510 calls @$21.00, collect $39,900.  Net credit: $3,000

C. Sell 25 Jun 520 calls @ $17.10, collect $42,750. Net credit: $5,850.

All three of these spreads are still profitable.

The current greeks tell us that risk has increased.  The position is

long more vega than we owned before, and theta has become even more negative.  But the long delta and positive gamma will prove to be very helpful if the market continues to rally.  We'll see how this imaginary trade eventually plays out, but if I owned one of these positions, I'd be inclined to take my profit because the position is long too much vega.

One compromise is to sell a small number of long calls, bringing the position nearer to neutral in each of the four greeks listed.  That would make the upside less attractive, but this position is risky to hold because a significant decrease in IV is possible, even if it's not likely. 

For example, the Jun 520 calls have a 37 delta, and selling 3-lots leaves the position long delta and reduces vega by approximately 200.

The idea behind looking at this trade is to illustrate that owning a small number of extra call options can produce significant profits when the underlying makes a good move.  But time decay and a loss due the position's positive vega (the portion of option's premium dependent on implied volatility) can cut into those profits.  But if you open a position such as this to provide upside protection for your portfolio - one that has negative gamma (such as an iron condor) then this type of trade can offset some, or all of the iron condor losses.

I'll update this hypothetical trade at least one more time - most likely May 22, using prices from Thursday May 21.  That's the last day of trading for the May options.

317

Diagonal Back Spread. Follow-up

This is a follow-up to the recent posts (three parts) about the diagonal back spread.  The idea of making the trade was to earn a good profit from a substantial upside move, without incurring any significant downside risk.

The image below represents a snapshot in time, and occurred  yesterday, late in the trading day.  At that time, the market had already backed off the highs for the day.  The purpose of updating this trade so quickly is to illustrate that you never know what's going to happen with some option trades.

Most of the time, when the market rallies, a decrease in option implied volatility is observed.  This time IV did not shrink.  In fact, despite the big upside move, RVX (RUT equivalent to VIX) is up fractionally on the day.  Thus, the trade is earning a profit from positive gamma - and the ever increasing delta of the position,  But, the bonus for this trade is that implied volatility is a higher than when the trade was opened. Because these positions are positive vega, the increased IV translates into increased profits.

Here are the option prices, a few minutes before the market closed yesterday (Thurs, 4/2/2009):

Comparing the cash available from closing the position with the values in the Tables, you can see that each of these trades is profitable.  Of course, they are fictional trades, but it's important to see that a profit was quickly generated when IV increased from a vega rich trade.

The first table represents the numbers from the original trade (RUT = 429) and Table 2 represents the price at which the trade (RUT = 450) can be closed (at least I believe the market makers would accept these prices and take the position off your hands).

Closing prices:  

 

Table 2

 

As you can see from the tables, each of the positions gained delta, lost theta, picked up significant vega, and is profitable (credit minus debit).

Note: Gamma is small and you may wonder how delta increased from 6 to 65 for position A.  Remember, gamma represents the delta gain for each point.  Thus position A gained approximately one delta for the first point, and fractionally more for each subsequent point that RUT moved. (Gamma was calculated to only one significant figure, and there's a rounding error.)

If I owned this position for a trade, I would have exited and taken the profit.  But, if I entered this position seeking a large profit from a large move, then it would be too soon to exit.  If I owned this for portfolio insurance (protecting an iron condor portfolio), I'd maintain ownership.

292 

Backspreads. Standard and Diagonal. III

Part III: The risk graphs.

Part I and Part II.

I discussed three different RUT diagonal back spreads last time.  Reminder:  These positions were selected randomly.  Thus, please do not try this at home.  If you are comfortable with this idea, carefully choose your own strike prices and underlying.  But these positions, or your own, are appropriate for a paper trading account.
 

RUT 429; (Closing price 3/27/2009) 

The y-axis shows Profit/Loss (multiply by 1,000).

P/L = 0 at current price (429).

The x-axis represents RUT price (multiply by 100).

Position A:

Sell 10  May 460C @ 16.70; Buy 16 Jun 500C @ 11.70

 

a) The position has positive theta.  That's true as long as there is significant time value remaining in the short option.  If RUT undergoes a significant move in either direction, the May options move towards 0 or 100 delta, and the time premium quickly disappears.  As that happens, theta for this spread becomes negative.

b) The position has positive vega. Thus, the final profit or loss can only be estimated.  So much depends on the price of your June options when it's time to sell.  Obviously, if you are satisfied with the profit (or unhappy about risk) at any time, simply exit the trade.

c) Note: This spread usually does not make a large profit, but it does provide the possibility of collecting when the market rallies.  If you are lucky and  RUT moves another 25% and if IV increases, there's money to be made.

d) There's another way to profit - and that's when the traditional diagonal spread would also be a big winner.  That occurs when the near-term option is inexpensive to cover, but RUT is still high enough for the Jun calls to retain substantial value.

Position B:

Sell 10  May 460C @ 16.70; Buy 19 Jun  510C @ 9.50

Buying 19 Jun 510 calls instead of 16 Jun 500 calls allows for the possibility of a larger gain.  But beware - if a move does not come quickly, the 19 Jun 510 calls will lose value more quickly than the Jun 500 calls.  

The position is + theta and vega (see Table below).  When vega is 408, the position makes or loses $408 when the implied volatility changes by one point; higher or lower.

Position C:

Sell10  May 460C @ 16.70;  Buy 25 Jun 520C @ 7.70

 

Potential profit is much higher, but theta is less (See Table).  Vega is much higher.  Thus, this position is far riskier then the others.  It's difficult to see from the current graph, but as time passes, the upside becomes ever more dangerous.  Right now this position works well on a continued rally, but if a few weeks pass, ans especially when IV declines, this can turn into a disaster.  [Sadly I lack the software to see these positions at a later date, but plan to post an update to these hypothetical positions.]

Table

3 Positions and the Greeks

 

DEBIT: Dollar cost to open position

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Backspreads. Standard and Diagonal. II

In Part I, I gave a brief description of a standard call back spread in which an investor buys more options than he/she sells.  The idea is to profit in a bull market when the underlying stock makes a big upside move - while minimizing (usually, eliminating) risk if the underlying moves in the opposite direction. 

Similarly, you may be able to profit in a bear market by owning put back spreads.

Back spreads allow the investor to own extra options and positive gamma.  Instead of paying for those options, the cost is reduced (or eliminated) by converting the position into a spread by selling fewer options that are closer to being in the money.  Typical back spreads allow the investor to profit when the underlying stock or index moves significantly in either direction. 

Because the focus of this series of posts is on diagonal back spreads, which are uni-directional, there is no need to dwell on that aspect. [But, if you want to understand how it works, consider yesterday's example.  Instead of selling May 90 calls, sell May 50 calls or stock.  Time decay becomes much worse, but gamma increases and if XYZ undergoes a serious decline, the back spread is very profitable - because the stock declines by far more than the May 90 calls would have declined.]

Diagonal back spread

The purpose of a diagonal back spread is to create an opportunity to earn a profit when the underlying makes a large move in one (specified) direction.  But, as with 'regular' diagonal or double diagonal spreads, there is the possibility of profiting when the option you sold is not far out of the money as expiration nears.  But keep in  mind that being short an ATM (at the money) near-term-option is a high-risk situation because of negative gamma.

Much of the profit/loss that results from owning a diagonal spread is dependent on IV (implied volatility) at the time you exit the position.  Diagonal back spreads are even more dependent on future IV  because you own extra options.  Thus, these spreads are especially rich in vega. [If that aspect of the trade bothers you, you can add some negative vega positions to your portfolio as an offset: sell credit spreads, for example.] 

I proposed the idea of diagonal call back spreads in Part I and suggested it's one method to profit from a major upside move  (use puts to play for the downside).  But there's one caveat:  Most of the time when the market rallies,  IV decreases.  That hurts a vega rich spread.  In very recent times, IV has not be declining on rallies, and for the moment, that specific risk may be minimal.

There are two ways to win with diagonal back spreads:

• A large favorable move - The sooner, the better.
  

• If time passes and your short options expire or are repurchased at a low price - as long as the market has not moved to a point where your long options have little value.
  

The Set Up

a) Choose an option to sell.  The idea is to sell a near-term (or 2nd month) option. 

You can choose an out of the money call - but not too far out.  This option must be trading at a significant price because you want to collect enough from selling these calls to pay (or almost pay) for the calls you buy.  The bakspread is not as effective when your cash outlay is large.  In that scenario, you'd be better off by simply investing the money in naked long calls - when looking for a big rally.

It's appropriate to sell an ATM option, if your comfort zone allows it.  Mine does not and I sell options that are a few strikes OTM.

b) Choose an option to buy.  This is a crucial decision.  If the market rallies and if IV declines, the best call options to own are those that with the lowest strike price (or highest delta).  But, if IV holds steady or increases, then the best options to own are those with higher strike prices.  Why?  Because you must own more of the lower delta options to achieve delta neutrality - and that translates into more vega.  If IV rises, it pays to own vega; if IV collapses, owning vega is costly. 

In addition, your potential upside win is larger when you own more options.  But be careful - time can destroy the position.  We'll look at risk graphs next time, but it's a good idea to use your broker's software to see how various positions make or lose money under various conditions.

Be careful here.  If you are considering the purchase of calls with a strike price of 700, it's reasonable to choose 710 or maybe 720 instead.  Don't consider buying 780s or 800s just so you can own a fistful of options.  That's a huge gamble that will cost dearly, unless IV explodes.

When trading an index, there are many choices.  That does not mean you can't adopt this strategy for individual stocks.  With stock, there are fewer choices - and that's okay (as long as you can build a position you want to own).

Each option has a different delta.  That allows you to build a ratio that appeals to you.  Because this idea is probably new to you, this is the perfect time to set up a paper trading account, open a variety of positions, and see how you feel about owning each of them - as time passes, and as the market moves.

EXAMPLE (Chosen almost randomly. Please do not make this trade.  The strike prices of the options you buy and those you sell should be as near to each other as possible.  But, the nearer they are, the more cash it costs to open the trade.  The only problem with a significant cash debit is that the spread can become a loser - if the market tumbles.) 

RUT is currently (Fri close) 429.

Sell 10 May 460 call @ 16.70; delta: -363

Buy 16 Jun 500 call @ 11.70; delta: +369

or   Buy 19 Jun 510 call @  9.50; delta: +352

or   Buy 25 Jun 520 call @  7.70; delta: +363

These are just three possibilities out of many.  You can sell Apr or May options and then buy May or Jun calls to hedge.

You can trade options with higher or lower strike prices - but it's important that the difference between the options you buy and those you sell are not 'too far' (a relative term) apart.

Next time: Choosing a spread

to be continued... 

285

Back Spreads. Standard and Diagonal

The market has been surging recently.  One way to participate is to be long.  Buy calls or call spreads, sell puts or put spreads etc.  But for those of us who (stubbornly) are not willing to do that, is there an alternative investment that provides an opportunity to make some money if the market continues to rise - but which is protected from loss if the market turns around and declines as rapidly as it rose?

Yes, there is.  A back spread is a position in which you begin by selling a call (or put) spread, and buy extra options.  In this example, we're looking to win on a continued rally, so we use calls.  It's those extras that give you an upside profit potential.  For example, instead of selling an XYZ May 90/100 call spread, you might decide to make this position delta neutral.

Back Spread Example:

Sell 10 XYZ May 90 calls
Buy 15 XYZ May 100 calls

Depending on the price of these options, which in turn depends on the implied volatility (IV), you can probably collect a cash credit when opening the position. [And you may want to buy more than 15, depending on the option's delta].

The good news about this spread is that it has an unlimited upside gain.  If the stock rallies far enough those 5 extra calls will pay off.

Unfortunately, this spread carries significant risk due to its negative theta.  If too much time passes, your long options will not increase in value fast enough to offset time decay, and you lose money.  If expiration approaches, and XYZ is trading near 100, there's the possibility that your long calls become worthless and the short calls can be worth about $1,000 apiece.  Not a pretty result.

That's the problem with a back spread.  If the market tumbles, you will be glad you didn't own calls because they would lose their value in a hurry.  If you have the back spread, and if you collect cash when opening the position, they you can earn a small profit (the credit) on the decline.  Back spreads are difficult for individual investors to manage, but are excellent insurance against a huge upside move for market makers and other traders with large positions.

So if it's not so good for you, the individual, why am I discussing this trade?  The answer is that this is similar to a spread can work out better - especially when you intend to own the position for more than a few days.  It's the diagonal back spread.  It has its own set of risks, and we'll look into those.

I've written about the diagonal spread before, but those positions consist of buying one call for every call sold.  The diagonal back spread involves owning extra calls.

I'll go into further detail next time and provide some risk graphs to illustrate how this position can work.

to be continued..

284

 

Q and A. Choosing Strikes; Iron Condor vs. Double Diagonal

Finishing Josh's lengthy set of questions:

Third, how do you pick the strikes for your positions? Do you use the delta of the short option? Do you look at chart support and resistance?

Fourth, though it seems that you mostly trade RUT, I wonder if you have a comment on why most people trade index ETF ICs (IWM, QQQQ, SPY, DIA) with two point wide spreads. I understand that one wants the hedge (the long strike) to move along with the short, and that two point is an effort to save on the commission that one would need to get the same credit for one point wide strikes, but why does everybody use two points, why not three? What I really want to know is is there a mathematical reason for this? Or is it just custom?

Fifth, you seem to talk mostly about ICs on the blog. I have asked you about calendars before and you said that you did not trade those very much, but I think you have mentioned that you trade double diagonals. If possible could you give a bit more information on how you trade double diagonals.

***

The Rookie's Guide to Options contains a discussion on strike selection, but I don't have iron clad rules.  If you are a user of technical analysis, then by all means sell calls just above resistance, and puts a bit below support.

My method - again, this suits my comfort zone - is to go as far OTM as possible when choosing options to sell.  But, I have a minimum $ requirement when selling 10-point wide RUT call or put spreads.  I try to collect $300 (for the whole iron condor) as a bare minimum for 12-13 week spreads.  That works out to a potential profit of $100 per month.  I don't hold long enough to collect all of it, but that's how I choose my strikes.  

Traders who prefer to trade options that expire sooner (and that's the majority of iron condor or credit spread traders), have their own methods, but I believe it's a bad idea to sell spreads for small premiums. 

 

I don't know where you get the data that 'everyone' uses two-point spreads when trading ETFs, but when trading, the options must be sufficiently far apart to allow you to collect a decent credit when selling.  It may be okay to trade an index spread for $150, hoping to make $100, but selling a QQQQ spread for 15 cents, hoping to earn a dime, is commission intensive and much more difficult to accomplish.

ETF traders may like the idea of tighter bid/ask spreads.  But, if an option with a strike price of 500 had a bid/ask spread of $1, that's the same as trading an option with a $50 strike and a 10 cent bid/ask spread. 

The advantage to choosing two-point spreads, rather than three, may simply be that three-point spreads make the options either too close to the money or too far OTM.  I know of no other edge.

I prefer European style index options and that's a big part of my decision.  ETFs are Amerian style.

I trade double diagonals ONLY when I feel IV is low enough so that there's little risk that it will go lower.

Others may trade the DD when looking for IV to be increasing over the lifetime of the position.  Because I prefer to predict as little as possible, and because IV is so much higher than it was just a year ago, I may not be using DD any time soon.

I choose my strikes as with iron condors.  I keep the difference between the calls (also the puts) as tight as possible (20 or 30 RUT points for calls and 30 or 40 for puts) - plus, I avoid paying a big (a relative term) debit for the DD.  That means I'm shut out when IV is high.  Your comfort zone may allow you to play in today's environment.  Mine doesn't.

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Learn First; Then Trade

The questions below were submitted by an option rookie to an online forum.  I don't want to take pot shots at someone who is troubled and is intelligently seeking help.  The problem is that he could have asked questions first and saved himself from being in an uncomfortable position.

Please don't let this happen to you.  Get an options education before you begin trading.

***

"On Monday [Nov 17, 2008], on the advice of an options newsletter, I executed this trade:

"SIMULTANEOUSLY SELL (TO OPEN) SPY 77 PUT, AND BUY (TO OPEN) SPY NOVEMBER 75 PUT, WITH A LIMIT OF 0.14 CREDIT OR BETTER FOR THE SPREAD."

I'm currently losing money on this, as SPY is heading downward.
I'm not familiar with credit spreads, new to options.

What am I hoping for in the above? SPY is now about $82, was about $86 the other day

But I sort of thought that if I'm buying/selling puts between 75 and 77 that the goal was to be in between the two for a break-even or above for a profit.  But as it's above even now...

Well I just don't understand the trade at all.

Can someone explain what the above trade would leave me with as far as potential loss, expected break-even point, etc..?

Thanks"

*****

I think it's a shame that this investor got trapped into trading options with absolutely no idea of how he was going to earn a profit or how much money was at risk in an attempt to earn that profit.  I have subsequently learned that he bought his first option book, but decided to trade while waiting for it to arrive.  I sympathize with that 'urgency' to get started because options can be enticing.  I remember being anxious to get started (in 1975).

To make matters even worse, this spread can earn a maximum $14 profit, before commissions. [NOTE:  My error.  I thought his was a September vertical spread.  I see that it's a diagonal.  Maximum profit is much higher]  Because he is new to options, he may have traded a small number of contracts, and the commissions could easily have eaten half to all of that tiny premium.

This is not a rare occurrence.  When a trader first hears about options, it's probably from a fervent options admirer and the excitement can be contagious.  But, you use real money, it's important to understand what you are doing first, and trade afterward.

The first problem is the newsletter.  I know most newsletter publishers have high integrity, but others just want your money.  They want their readers to make lots of money.  But, let's face reality.  If these people had a trading system that produced profits consistently, do you think they would sell subscriptions for a few measly dollars?  Wouldn't it be far more rewarding to trade their own picks and make a fortune? 

But, there's something far more important that these newsletter publishers completely ignore - and I discuss it frequently.  Suitability.  It's simply wrong to recommend a trade to 'everyone.'  Each individual investor or trader has his/her own comfort zone and tolerance for risk.  Selling a spread for fourteen cents (less commissions) when the potential loss is $186 plus commissions is not very good advice.  Sure the trade  began with a high probability of success, and still has a reasonable chance to be a winner, but the risk/reward ratio is way out of line.  This trade is simply unsuitable for an option rookie.  In my opinion it's not suitable for anyone, but that's probably going too far.

For any readers who want the answers to his questions, the break-even point is $76.86 (in reality it's higher because of the commissions involved).  The maximum loss for the trade is $186 (plus commissions), but it's even worse than that. [Again, these are incorrect because I missed the fact that this is a diagonal]

If SPY finishes between 75 and 77 and this investor fails to buy back the Nov 77 puts, he will own shares on SPY on Monday, following expiration.  That will possibly result in a margin call and a forced sale.  But, even if the sale is not forced, he will find himself owning shares of SPY, and it's not likely he wants to do that.  Thus, if the market opens lower Monday, his loss will increase, and may even exceed the current 'maximum loss.'  Of course, Monday may bring a bullish opening, and he may end up with a profitable trade.  But it's a gamble he probably prefers not to take.

I hope this investor comes out okay on this trade.  But more importantly, I hope it serves as a lesson learned.

Please avoid this trap.

169

Recommended Option Strategies: Double Diagonal Spreads

Double diagonal spreads are similar to iron condors, with one significant difference:  the options you buy expire after the options you sell.  Thus, a double diagonal spread is equivalent to buying an iron condor and buying two calendar (time) spreads.

Definition of a calendar spread:  A position consisting of two options of the same type (both calls; or both puts), on the same underlying, with the same strike price.  The options have different expiration dates.  When you buy the calendar spread, you own the option that expires later.  You must pay a debit to own the calendar spread.  When you sell the calendar spread, you own the option that expires earlier and collect a cash credit.

The idea behind this strategy is that the calendar spread tends to increase in value as time passes and the underlying asset moves towards the strike price.  It’s not ‘easy  money’ because when the underlying moves away from the strike price, the investor often loses money.  This is a very popular strategy among individual investors.

When a situation calls for a calendar spread, I prefer to trade a double diagonal instead.  That strategy is the same as owning an iron condor with two calendar spreads:

Reminder: You can find a description of an iron condor here, with additional details here.

Example of a double diagonal spread:

Sell 5 ZYY Apr 80 calls; Buy 5 ZYY May 85 calls; and

Sell 5 ZYY Apr 65 puts; Buy 5 ZYY May 60 puts

Note:  If you bought Apr 85 calls and Apr 60 puts (instead of the May options), you would own an iron condor.

When you buy the iron condor, you always collect cash.  When you buy the double diagonal spread, sometimes you pay cash and sometimes you collect cash.  Why? You collect cash when selling the call and put credit spreads, but you pay cash for the calendar spreads.  Sometimes the calendars cost more than the credit spreads and sometimes they cost less.

As with an iron condor, this position earns the largest profit when the near-term options expire worthless.  At that time, you sell your long calls and generate cash.  When that cash is more than the cost to open the double diagonal spread, you have a profit.

When you buy a double diagonal spread, when the near-term options expire (or are repurchased), you still own options.  The value of those options depends on two factors:

•        How far out of the money they are

•         More importantly, the implied volatility (IV) of the options.

IV is a topic we have not yet covered on this blog, but you can find an explanation geared to option rookies here.  In a nutshell, the more volatile the market is expected to be - before the options expire, the higher the price of options – both calls and puts.  Thus, if IV is relatively high, you sell your options at a relatively high price.  Similarly, a low IV environment means you will receive less when selling your options.  This dependence on IV makes it difficult to estimate the maximum potential profit for a double diagonal spread.

NOTE:  It’s not necessary to trade a double diagonal.  If your intention is to sell a call spread or a put spread (instead of an iron condor), you can choose the simple diagonal spread. 

Example:

Sell 8 WXY Dec 220 calls

Buy 8 WXY Jan 240 calls

Diagonal and double diagonal spreads are attractive when you believe implied volatility is low, and will be higher in the near future.  Otherwise, it’s less risky to trade the iron condor.

57