Part III: The risk graphs.
I apologize. All graphs were lost when the blog was migrated to WordPressPart 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).
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.
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.
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.]
3 Positions and the Greeks
DEBIT: Dollar cost to open position