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.

Doublemint3x

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

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4 Responses to Trading Double Diagonal Spreads. Part I

  1. Erin 06/19/2009 at 2:32 PM #

    Hi Mark,
    I was wondering if you had an opinion on ratio spreads and BWBs? Would a something like a 1:2 put ratio + 1:2 call ratio have any advantage over an IC, particulary with regards to adjustments?
    Look forward to hearing your thoughts.
    Erin

  2. Mark Wolfinger 06/19/2009 at 3:08 PM #

    Erin,
    Ive treid to reply, but I cannot stop writing.
    I’ll get this posted as a blog post when I finish.

  3. JCVictory 06/20/2009 at 4:27 PM #

    Mark,
    Great article!
    In the article “The Double Diagonal”, Tom Preston of Thinkorswim writes:
    “But you could start to look to roll when the current value of the short option is less than 10% of the difference between the long and short strikes of the double diagonal. In the case of the June 111/119 July 109/121 (SPY) double diagonal, the difference between the long and short strikes is 2.00. 10% of 2.00 is .20. So, when the short June 111 puts or 119 calls trade around .20, you could start to plan on rolling them.”
    What would be your professional opinion on this method of using the price of the front month short options as a guide to close (rather than roll) a diagonal spread?
    Regards,
    James

  4. Mark Wolfinger 06/20/2009 at 9:53 PM #

    Thanks James,
    I look at double diagonals from a different perspective than I look at iron condors, despite the fact that they are similar strategies.
    One thing I don’t like to do with DD positions is to ‘roll’ them. And apparently you don’t either, based on your question. But for those who would consider that action, let’s begin by commenting on that choice:
    I have no idea what Tom is referring to, but my guess is that he wants to cover the front-month option, and sell a new option that converts the old DD into an iron condor (i.e. sell Aug 400 when your long from the DD is Aug 410 or 420).
    If that’s the goal, I’d need more information. For example, if I cover the near-term short by paying that 20 cents, what can I collect if I simply close the DD? Does it make sense to roll instead (obviously an individual decision)? Do I want to own the new iron condor, or that a risky position? Would I rather take my profit and close the DD?
    I believe in simplicity, but Tom’s quote is just too simplistic. I’m sure his complete story includes the necessary details, but I would not follow his advice – if your summary is all there is. My comfort zone says close and open new DD, and not roll into an IC just because I already own half of that IC (the long options).
    Now to your question. I don’t think the idea of closing when the front-month can be bought at a specific price is a bad idea. But, it’s too limiting for me and I don’t believe it’s viable.
    I can visualize many situations in which I’d be happy to pay $2 for the front-month option. For example, expiration is just a few days away and IV has spiked. That high IV tells me I’m going to get a great price for my long options, and I’d rather sell that long option now – when the price appears to be ‘high’ – rather than hope it will still be high in a day or two. I’d ignore the fact that I’m paying almost $2 more for my short than I would like to pay. If I can get $4 more for my long option than I expected to get, closing now is an extra $200 per spread. I’ll take that and let someone else go for the extra decay on the front month option. I’m trading based on the rice of my spread position, not based on the price of one part of that spread.
    The point is that Tom’s idea does not work for me in the above scenario.
    But, if the DD is a call spread and the market is falling, then there is a point at which I must exit the trade to salvage as much of the net credit as I can. It may turn out that paying 20 cents for the near-term option turns out to be a good time to exit, but so much depends on IV and the amount of time remaining before the front-month option expires that I don’t believe this is a workable method.
    With an IC, there is very little to gain by holding when the spread is cheap. With the DD, the price of your long option is very important and is often the KEY to determining how well this spread has worked. IV plus time remaining are very important factors in determining the price of your long. Much more important than the price of the front-month option.
    I vote thumbs way down on that idea.
    PS. What I need is a way to write less.

Please share your thoughts.