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.


2 Responses to Diagonal Back Spread. Follow-up

  1. slait73 04/03/2009 at 8:58 AM #

    Sorry Mark, you´ll probabily remember my yesterday question.
    I think I´d like to roll to for example 530/540C, but may be it´s not a great idea ´cause if I pay (now) 2,60 for rolling from 460/470 I can´t see the way of having a profit ´cause with the put spread I only earner 2$.
    I wouldn´t like to close the IC, and rolling the put spread is very dangerous….

  2. Mark Wolfinger 04/03/2009 at 9:15 AM #

    Sadly there is no solution to this problem that guarantees success.
    1) You can do nothing. I don’t like this idea – if you are currently uncomfortable holding your current position.
    2) If you concentrate of giving yourself a chance to earn a profit, it becomes very difficult to manage risk. To me it’s far more important to prevent a large loss. You can earn a profit on your next trade. But that’s the way I think. Perhaps maintaining a profit possibility is more important to you. It’s a personal decision.
    3) You did receive $400 for this iron condor. If you spend $250 to make the call position better, you still have a good chance to earn a nice profit.
    4) If you want to spend less than $200, you can roll to 510/520 instead. That costs less cash, but involves a larger chance of being in trouble again. Based on what you have told me, this may be the best compromise for you.
    5) You can change the position in stages. For example, roll only 25% of the position now, hoping you will not be forced to roll the remainder later. If you only have one or two lots, then of course, you cannot do that.
    The bottom line is that you must decide if you are too uncomfortable holding this iron condor. When I feel it’s too risky, I take my loss and open a position that is more comfortable to own. I’m not telling you to do that – managing risk is a very personal decision.