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.

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6 Responses to Diagonal Back Spread. Follow-up II

  1. Hi Mark,
    If I understood,10IWM is equivalent to 1RUT.
    Looking in the TOS I found that an IC of both with the same probability of 80% for june the credit of IWM is 0.26(x10= 260$)(delta of short 9)and the credit of RUT is 1,35 (=135$)(delta short option 5).
    I think delta is more important than the probabilities why is that having the same prob there are different deltas and so different credits?
    I selected June RUT 600/610/380/370 and IWM June 61/63/39/37
    THKS
    Antonio

  2. Mark Wolfinger 04/30/2009 at 6:50 AM #

    Antonio,
    Yes 10 IWM is similar to one RUT option.
    1) The RUT strike prices are 10 points apart and the IWM strike prices are equivalent to being 20 points apart.
    2) When the strikes are equivalent to 20 points apart, the credit should be almost (but less than) double. That’s what you did here.
    Your potential reward is $260 vs. $135 and your maximum loss (and margin requirement) is $1740 vs $865. These positions canot be comparead with each other, unless you trade only 5 IWM spreads.
    Twice the risk and twice the reward. I don’t know what probability you are measuring, but they cannot be equal.
    3) When you say ‘probability of 80%,’ what does that mean? The proability of ??? is 80%.
    Is it the probability that your short option will finish in the money?
    Is it the probability that one of your short options will touch the strike price before expiration arrives?
    Is it the probability that the trade will lose money?

  3. I suppose is prob that short option finish ITM.
    Thank you for the explanation it´s logical…got to think a litle more, but continue confuse about the Probability.

  4. GMG 04/30/2009 at 10:57 AM #

    Mark,
    Could you help me understand why IWM strike prices are equivalent to 20 points apart? I’ve been using them as ‘pre-insurance’ in combination with RUT iron condors. Putting on 1 long IWM strangle for every 1 RUT IC, which saves me some $ on commissions compared to buying 10 IWM condors. But I’m concerned that I am missing something important, since I was under the impression that IWM was ~ 1/10 of RUT.
    Thanks!

  5. Mark Wolfinger 04/30/2009 at 11:06 AM #

    Yes, IWM is ~ 1/10 RUT.
    You know the answer; you simply read the original post too quickly.
    The strike prices chosen for the IWM were two points apart – not one point apart. The 61/63 spread is similar to the 610/630 RUT spread.

  6. GMG 04/30/2009 at 11:13 AM #

    Oh…you’re right, I didn’t read it carefully enough. When I saw 20 points, I had a moment of panic that I may have missed something fundamental about IWM. I’m just second-guessing my decisions too much with the current rally…
    Thanks for answering an obvious question though.