I have a question on ratio diagonal spreads that I was hoping you could answer for me.
The spread is as follows: Sell 1 ITM Option, Buy 2 OTM Options where the IV of the front month option is higher than the IV of the back month options (e.g. Sell 1 ITM Nov Call, Buy 2 OTM Dec Calls).
I noticed that the position will lose money if the IV of the Dec options (the ones I am buying) declines. What type of adjustments can be made to this position if the IV of the long options starts to decline?
The backspread is one strategy that I seldom discuss, primarily because it's not easy for individual investors to manage.
The diagonal backspread is a separate category and is worthy of a discussion.
By definition, the backspread is an option position in which the trader owns more options than have been sold. Thus, your 2:1 spread qualifies as a backspread.
When owning options that expire later than the options sold, one unchangeable characteristic of the position is long vega. Thus, the P/L picture is significantly affected by changes in the implied volatility (IV) of the options – between the time the position is opened and closing time [And that's true whether you exit voluntarily or hold through expiration].
The simplest method to guard against an IV decline is to sell vega. And the simplest method for doing that destroys the very reason you opened the trade in the first place. That method is to change the diagonal backspread into a 'regular' backspread. For example:
a) Sell two Dec/Nov OTM calendar spreads.
This leaves you with the Nov back spread:
Long two Nov OTM; short one Nov ITM
It is not likely that you want to own this position
b) Sell one ITM calendar spread
This leaves you with the Dec back spread
Short one Dec ITM and long two Dec OTM
This idea is unsuitable. Traders who use diagonal back spreads have a very different market outlook (expiration to arrive with the near term option's strike price being near the underlying price) than those who own same-month backspreads (hoping for a very big move – so big that the ITM option is very far away from the price of the underlying).
It's nice when the simple method is viable, but in this case it is not.
A more complex solution is to add new positions with negative vega to your portfolio. However, this requires trading several positions simultaneously, and not every trader wants to do that.
In my opinion, no single strategy is good enough to use all the time. We must pick and choose our spots. When IV, as measured by VIX, or better yet, the IV of your specific underlying, is relatively high – and you have no reason to anticipate that it will move higher – that is not a good time for owning positions that are vega rich.
I get it. You still want to make the play that pays off when expiration finds the stock trading near the strike of your ITM short. If you have a very strong predictive ability, and if you want to make that play, there are alternative strategies that have less vega risk. (Butterfly for example).
However, if you predict market direction and future prices, then you should be willing to predict the IV direction as well. There's no need to get it exactly right. But, if you believe it's not going higher, I would avoid the diagonal backspread. That spread is most appropriate when you have some reason to anticipate that IV will not be declining over the next few weeks.
I agree that this is something difficult to predict, but the diagonal backspread comes with vega risk. You must deal with it or only accept that risk only when willing to do so.
If you insist on using this strategy because you had good results, consider trading smaller size when not confident about future IV direction, and larger size when confident it will incease.
Another possibility is to divide your trade into two parts. One is to use your diagonal, but in addition, perhaps you can sell a credit spread with strike prices that suit your prognostication. That credit spread comes with negative vega. It won't have as much vega as your diagonal backspread, but it is a hedge in that it partially offsets vega risk.
The bottom line is that it is easy to hedge delta risk, but vega is another matter. The hedge is to sell vega, and that is difficult when owning diagonal backspreads.
Free: One Year subscription to Expiring Monthly: the Option Traders Journal for opening and funding at account at tradeMONSTER