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Managing Double Diagonal Positions

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Hi Mark,

Some specific questions [as follow-up to this post]: if the spread benefits from the price coming
close to the strike of the short option, and gets hurt by the price
shooting across it, why not wait for the price to go through the short
strike by a small amount and then close down part of the position and
progressively close down more of the position as it advances further? 

Why not do that?  There is no reason not to adopt that style.  If that seems to be a reasonable method of risk management to YOU,
then go for it.  Obviously it allows for the maximum possible gain when things go your way.

Just remember that there is real danger – both from the negative gamma (it's worse for a DD than an IC) and vega risk.  To compensate, gains from time decay are very attractive

If
YOU don't feel the loss potential is too large; if YOU don't feel
queasiness with risk: if YOU think this is a good approach, then it IS a good
approach for you.  The fact that I would not do this should not make any difference to you.

There is no single best way to manage risk.

If
we do buy insurance as the price moves towards the short strike and the
insuring option (even at a ratio of 1:5) is not as far OTM as the short strike, it
is likely to be expensive (due to the high delta, and volatility may or
may not contribute to the cost), and can at best mitigate the damage.

Yes.  Insurance is expensive.  Especially when it is less far OTM than the option it is protecting.

Let me nitpick on terminology. When I buy insurance, I buy it before it is needed, despite the fact that it may never be needed.  Then it is truly insurance. 

When I buy it 'as needed,' it's more of an adjustment, and not insurance.  An adjustment is needed – right now.

Insurance does far more than mitigate the damage.  If you choose to buy calls or puts (not spreads), the cost is higher, but the protection, and hence profit potential, is UNLIMITED.

Of course I am sure you will bring up the fact that the short strike can
be breached rapidly and decisively and that always happens when I get
into such situations!

I wasn't going to mention it.  A rapid breaching of the short is just
one of the risks that must be taken into consideration when choosing how
to manage risk.  Good things can happen (market stops moving against you).  Bad things can happen Large, rapid strike price breach).  Your
job is to be certain that the large loss does not occur.

One way to do that is to play
aggressively, per your first question, but cut position size. That
certainly cuts risk and should make you less uncomfortable when danger
looms.

Also why not open a diagonal in all iron condors (smaller position) on
the downside since the volatility will usually increase on the way down.

There are problems with diagonalizing all
put spreads.  The initial cost is high – and that's very true now, when IV is far above its long-term average.  IC traders collect premium. 
Paying a debit for the put spread may not feel comfortable to them. 

The problem is that a big rally can result in a loss for the put portion (when you pay a good-sized debit).  In that case, you
lose on both the call and put spreads at the same time.   Not a good result.

Second,
as mentioned in a recent reply 'weighted vega' is an
issue.  In most cases, IV for the front month option increases by more
than that of the option you own.  If the difference is large enough, you
actually lose on an IV increase.  This is a topic I have pretty much
ignored until now, but I recognize its importance.

I am also intrigued by your choice of short strike that is two months
out. Does it mean that you never hold these to expiration of the short
strike (with the exploding gamma risk), and if not what are your profit
targets? 

Here's what I have to say about 'never.' 
I never have iron clad rules.  Sure, I hold to expiration week when I do not
want to exit at the available prices.  

My plan is to be out of each trade 3
weeks prior to expiry  [I've already covered a bunch of October 2010 short
positions (calls earlier and puts now)].  But residual positions are
sometimes priced where I don't want to buy them. 

It's not profit vs.
loss that matters – it's the price of the position NOW that affects my decision.  If I don't want to pay the price, and if the risk profile makes me willing to hold for one more day – I do so and then make another decision. Finally one of two things happens.  I get my price, or risk becomes uncomfortable and I exit.

I have no specific profit targets with double diagonals.  I exit the side that is far OTM – when I am satisfied with the cash credit available [I would never pay a debit under these circumstances] or when delta turns (example: This portion of the trade becomes delta positive on a down move).

I exit
the side that's closer to being ATM when I like the cash credit I can
collect when exiting.  Because IV plays a huge role in the price of the
options, I cannot plan a specific dollar profit.

Thanks

Rajesh

793


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