Trading Double Diagonal Spreads; Part II

Part I

Double diagonal (DD) spreads provide profit opportunities that are not available to iron condor (IC) traders.  But, from the point of view that it's possible to lose more money per spread with a DD than with an IC, they can be riskier investment choices.  One immediate disadvantage is they they have higher margin requirements.  While reasonable brokers have identical margin requirements for an iron condor as they do for either of the spreads that makes up that IC (no additional margin to sell a put spread when already short a call spread). That's not true with diagonal spreads.  A double diagonal has twice the requirement as a single diagonal.  That makes no sense to me, but I have no influence over brokers and their rules.

The margin requirement for a diagonal is the difference between the strike prices, less the credit collected (if any), per diagonal. 

Trading RUT iron condors, I choose strike prices that are 10-points apart.  These simply feel comfortable to manage than when the strikes are near each other – but that's a personal comfort zone decision, and not a recommendation.

When trading diagonal or DD spreads, I use strikes that are farther apart.  I confess that this is not based on a sound, mathematical rationale.  It's based on the fact that I prefer to own a diagonal spread that provides a cash credit, or a small debit.  Because of the pricing of RUT options, most of the time I own a diagonal spread in which the strike price of my month 2 long is 30 points away from the strike price of my month1 short.   Occasionally I buy the position when the strikes are only 20 points apart and find these 20-pointers to be easier to manage.

If RUT marches strongly through the short strike, the maximum loss can approach $3,000 per spread (less any time premium remaining in the long option).

I look at it this way (referring to just the call spread, although this point applies equally well for the put spread):  If I have a position similar to: 

 Short 10 GOOG Sep 470 calls

Long 10 GOOG Oct 480 calls

the position is not going to do well on a quick upside move through 470.  Thus, there's upside risk.  If I pay a big debit to open this position – say $500 – then there is also downside risk.  If GOOG drops too far, especially if a few weeks have passed, both options may quickly move towards zero and most of that debit can be lost.  Thus, I trade these spreads to avoid the chance of losing in both directions. [Yes, if it's a double diagonal, the downside move threatens the put spread, but at least it will not also hurt the call spread.]

 

DD Opportunities Absent from IC

To offset that extra risk, there are profit
opportunities not possible with iron condor positions.

1. If the stock moves toward one of the strike prices – and especially if some time has passed, instead of facing a loss as the iron condor trader would be facing, there's a good chance that the diagonal spread could be closed profitably.  Whether that comes to pass is going to depend on how much time remains before the front-month option expires, and the current implied volatility of the calls you own.

2. If closing doesn't appeal, and you prefer to hold this position, selling the calendar spread when it is nicely priced (the stock trading near the strike price increases the value of a calendar spread) allows you to take cash out of the trade.  In the GOOG example, you sell your GOOG Oct 480 calls and replace them with Sep 480 calls.  That's selling changes the position from a DD to a combination spread.  It's half an iron condor on the call side and remains a diagonal on the put side.

If the position soon becomes risky to hold, you can use some of that newly- collected cash to pay for an adjustment.  Alternatively, you may elect to exit.

3. If enough time passes and if the underlying moves far enough away from one of the strike prices, you may be given the opportunity to repurchase one of the options you sold at a very low price.  Looking at that GOOG spread again, if the GOOG SEP 470 calls are available, you may decide to cover them by paying $0.20.

When you do that you have two good choices.  The first is to sell the Oct 480 calls, closing half the DD and probably earning a decent profit.  The second choice is to sell the Oct 470 call spread, converting the call portion into half of an October iron condor.

Deciding which is better is going to depend on the price you can collect for the Oct 470 call and how attractive it looks to own that specific GOOG Oct call spread.  Do not make this trade unless you want to own the position.  There's nothing wrong with exiting the trade.

The possibility  described above was discussed in the comments to Part I.

4) If IV explodes higher and if your underlying has not moved so far that your position is endangered, you can collect on that IV surge by selling two calendar spreads and converting the DD (which you want to own when IV is low) into an iron condor (which you prefer when IV is high – because it's too costly to buy the vega-rich DD spreads).  Of course, if it's attractive to do so, you may choose to exit the DD instead, and pocket the profit.

The new IC may run into trouble in the volatile market, but selling the two calendar spreads allowed you you own this position at a very favorable price.

Double diagonal spreads are more flexible than iron condors, but they are rich in vega and you want to own them only when you believe IV will be increasing – or at least not decreasing.  If IV feels too low to be trading iron condors, you may decide to compromise and own both iron condors and DD spreads.  Or you can open the combo spreads: Half an iron condor on the call side and a DD on the put side [or vice versa, but a downward move which hurts the put side of the IC may not be hurt as badly when you own the extra vega that comes with the diagonal].

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