In this final installment (for now), I’ll share more of my ideas about trading, and options trading in particular.  The purpose is to provide guidance for readers.  I’m not suggesting that you agree with, and adopt, all (or any) of these ideas.  Instead the purpose is to get you thinking about your own philosophy of trading and why my ideas may or may not be appropriate for you.

The bottom line is there’s more to option trading than merely slapping on a position and then waiting for the options to expire.

1) Make the best decision you can at the time the decision must be made.  Do not berate yourself if it turns out not to be the winning decision.

2) Stay within your comfort zone.  Never ‘hate’ any position you own. It’s easy to exit and find a better trade.

3) “It’s not good enough to find winning trading techniques; one has to continually adapt these techniques to an ever-changing environment.” So says, Dr. Brett – and I agree.

4) Don’t depend on ‘hope’ to salvage a bad position.  Use your intelligence to make a good trading/risk management decision.

5) I find that it’s too risky to try to earn every every last nickel from a trade.  Exiting a position early locks in profits and gives you a quiet period with no risk.

6) Don’t sell naked options.  The exception is for investors who want to buy stocks as prices decline.  For those investors only, writing naked puts is a satisfactory strategy.

7) Don’t use options to gamble.

There’s always more to say on any topic.  If you are so inclined, please share any of your basic trading tenets.

One way to think about a diagonal spread is to decompose it into a vertical spread and a calendar spread. The example he uses below is

+10 GOOG Oct 480 Calls
-10 GOOG Sep 470 Calls.

This is equivalent to:

Vertical Spread

+10 GOOG Sep 480 Calls
-10 GOOG Sep 470 Calls

And a

Calendar Spread

-10 GOOG Sep 480 Calls
+10 GOOG Oct 480 Calls

We just add and subtract the Sep 480 calls. I find it easier to use the two positions to think about the diagonal since they have different characteristics that combine into the diagonal.

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 that 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 month2 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 condo 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 to 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 some iron condors and some 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].

Erin asked:

Let’s also assume that the short option is 10 points farther OTM than the long option.

The last assumption is that we will exit a position as the adjustment of choice.

***

Iron Condor

With an IC, you are short a call spread that can become worth $1,000 (worst case); and you sold it for far less.  Our responsibility as risk manager, is to prevent that (or any similar loss) from happening.

The danger occurs as GOOG approaches 440.  If holding or closing the trade is the only consideration, I recommend establishing a maximum acceptable loss, and if and when that point is reached, exit.  That may when the call spread reaches $4, or $5, or whichever price your comfort zone allows. [Remember that if you bought the IC and collected $3 originally, then paying $5 is not the disaster it would be if you collected only $1.]  Your decision is when to pull the trigger.

Ratio Spread

With a ratio spread, you face a far different situation.  This time you own the 440s and are short twice as many 450s.

There’s the good news:  You own a spread that is ITM and is heading towards the point where it will reach maximum value of $1,000 (if it remains there at expiration).  So that’s a better situation than you faced with the iron condor.

But, you are short two calls instead of only one, and the second is a naked short. Some brokers do not allow customers to carry naked short call positions.  But, if you are allowed to do so, it’s considered to be a risky trade and I no longer allow myself to own such positions, but that’s not the point of this discussion.

Once GOOG moves past 450, then the naked short option quickly eliminates any profit you had from the 440/450 call spread [Mentally breaking this trade into two parts: the call spread and the naked short].  In fact, if there is much time remaining before the options expire, the position quickly turns into a  loser, with the loss mounting as the stock rises.

When there’s very little time remaining, the position still has terrible negative gamma, but the limited time prevents the extra 450 call from exploding.  If time runs out (the market closes on expiration Friday), and if GOOG is under 460 (your break-even point if you paid zero cash to establish the position), things are not too bad.  Obviously, a lower price is better.

The major factor in deciding whether to hold or exit is going to be time.  With expiration rapidly approaching, you may still want to exit because you probably have a profit (although it’s only risk that should matter, but I know that most traders only want to know if they have a profit or loss, and risk be damned.  This is not good thinking, but it is the way the world turns).

Thus, it’s possible to have a good profit as the stock moves towards 450, and that profit possibility makes this trade look ‘better’ than the iron condor – which has virtually no chance of being profitable as GOOG moves towards 440 – a full 10 points lower!

The ratio has a higher profit range, but there is that ‘unlimited loss’ possibility that makes it more dangerous to own.  In response to your question Erin, I’d rather have the adjustment decision with this position than with the iron condor.

This is just another personal comfort zone decision.  The optimist  understands that the stock is currently at its sweet spot, but danger looms.  The pessimist sees the danger, and may fold in the name of safety.

These are interesting positions to own, but I have removed them from my arsenal of strategies – just because I do not want to face a margin call (whcih can happen as the stock rises) or a nightmarish stock market opening gap.

Broken-Wing Butterfly

With a BWB, you are short a 20-point spread, and the maximum loss is $1,000 less the premium collected to open the trade.

This is essentially the same as the ratio spread, but this time you are not naked short any options.  You own the 470 call and there is neither a potential margin call nor an unlimited loss in your future.

I’d treat this spread the same as the ratio spread because it is the ratio spread.

Erin,

I hope that helps.  The iron condor is really the odd man out.  The other spreads are similar to each other and the IC trades very differently.  IMHO, the ratio (better yet the BWB) is easier to adjust because time is THE consideration.  Iron condors are risky at all times (if the short strike is approached).