ITM Diagonals aka 3-Day Spread

A lot of range bound trading this past week. It’s too easy to get chopped up during those times and directional positions almost always lose value regardless of which direction you’re trading. Good time to sell Iron Condors, right? If the range is small enough, yes. However, if the range is fairly large then short Iron Condors can see fairly large drawdowns which often causes traders to bail on the position for a loss just before price reverses and moves back towards the center of the range. So what do I trade during a ranging market? First, a range is only obvious in hindsight, not so easy to spot during trading hours. I need a position that doesn’t lose too much money if price moves away from the range that I think is developing but that provides a nice reward if it does stay range bound. Plus, I like to still have a directional component even with my range positions. Price can only do one of three things by the expiration of any given position; price can go higher, lower or remain unchanged. Give me a guaranteed profit in 2 of those 3 possible outcomes and a possible profit in the third and I’m good with that.

I frequently initiate SPX Diagonals that expire in approximately 2 weeks. I always choose the Friday/following Monday expiration. So the duration of the trade is approximately 2 weeks and the difference between the short and long option expiration is 3 days. Why the 3 day difference and why Friday/Monday expiry? Time spreads such as Diagonals and Calendars are sensitive to the Vega or the underlying Implied Volatility (IV) of the short and long options. A time spread is ‘relatively’ cheap when the IV of the long option is less than the IV of the short option. It’s considered expensive when the reverse occurs. Since I’m buying a time spread I want to get it cheap, right? Who wants to overpay for anything? It just so happens that almost every SPX Friday/Monday Diagonal or Calendar has that positive IV skew which gets the trade off on the right foot. Smaller accounts can use SPY instead SPX because these same SPX trades that I’m showing here can be done for just 10% of the cost by using SPY. Lets check out a few examples.

All of the risk profiles I’m showing below are based on the SPX Friday closing price of 3557.54. If I wanted a position that would be profitable if price was less than about 2% higher over the next 2 weeks then I could buy a $10 wide Dec7/Dec4 SPX 3575/3565 Put Diagonal spread for $8.30 ($830). Since it’s a $10 wide spread then I know if I pay less than $10 to buy it I’ll have a profit no matter how low SPX price goes. The peak profit occurs at the strike of the short option. Since this is a defined risk position I can only lose the amount that I paid for the spread. That’s if I don’t close the position early. One of the strengths of this type of position is the ability to close it early! If price exceeds the top of the range that I was expecting would hold then I exit the position at a relatively small loss because these position have a small initial Delta. That simply means that the directional risk is moderate for the first few days.

If I wanted a position that would be profitable if price was less than about 1% higher over the next 2 weeks then I could buy a $10 wide Dec7/Dec4 SPX 3550/3540 Put Diagonal spread for $7.60 ($760). That essentially pushes the whole spread down in price and, by doing so, lowers the cost of the spread. That also increases the position’s potential profit. Its a trade off between profit/cost vs. how much room I have to be wrong if SPX does go higher. See the risk profile below.

If I wanted a position that would be profitable if price was less than about .5% higher over the next 2 weeks then I could buy a $10 wide Dec7/Dec4 SPX 3525/3515 Put Diagonal spread for $6.95 ($695). See the risk profile below.

Finally, below is the risk profile of two $10 wide SPX Put Diagonal spreads for a total of $15.25 ($1,525). This is just combining two of the three above Diagonals into a Double Diagonal. It is obviously quite a bit more expensive but it greatly opens up the profit potential area.

This strategy is obviously appropriate for a range trade but it also can be used as a directional trade. Even when I feel confident that a directional move is likely based on a chart pattern or signal there’s no way to know what the size of that move might be. This in-the-money (ITM) Diagonal spread will show a profit regardless of the size of the move. A smaller move will allow for a much larger profit than a bigger move. Also, a larger move followed by a retracement in the opposite direction, a very common occurrence, would move price back towards the greater profit area of the spread.

I frequently have a SPX Diagonal open as a part of my overall portfolio. It generates the positive Theta that offsets the negative Theta that many of my directional trades have. I believe the key to managing these positions early in the trade is not allowing price to move against the position for more than a day. This position moves from positive to negative Theta quickly if price moves against it. Within the last hour of every trading day I check on the Diagonal to see if price is still within the desired range. If it’s not, I’ll exit the position with a relatively small loss. I will then initiate a new Diagonal that better fits with what the current price action is indicating. Let’s look at an example from this past week.

Tuesday morning would’ve been a good time to initiate the SPX Put Diagonal. As soon as SPX dropped below 3600.16 and the daily candle changed from a 1 to 2d (2 down) the Dec7/Dec4 SPX 3610/3600 Put Diagonal could’ve been bought. Even if that entry was missed, an even better entry would’ve been just prior to the close. Why wait until later in the day? The closing price ‘locked in’ the daily candle as 2d. If Tuesday’s price had instead rallied strongly after breaking below Monday’s low and closed above Monday’s high, then the daily candle would’ve been a green 3. That would not have been the right time to buy a Put Diagonal. So, the lesson here is that it’s often preferable to wait until later in the day to enter a new position.

Using the TOS ThinkBack feature we can see what the closing price of the Dec7/Dec4 SPX 3610/3600 Put Diagonal was on Tuesday.

Move that position over to a risk profile and you can see how that position would look currently. Notice how the Delta is just -1.76. Not much directional risk. Theta is 31.36. Getting paid for the passage of time. All good so far. The return on the position’s risk is already 40%. No reason not to hold this for at least another day…

…but what if I wanted to Delta hedge the position anyways? At Friday’s close I could’ve reduced position cost by almost 90%! Doing that then means I no longer can show a profit if SPX continues to decline in price but the profit range is still quite large. As usual, there is always a trade off anytime a position is adjusted. Each trader must decide for themselves whether or not a trade adjustment is advised.

That’s all for today. Post any questions or comments on the Twitter feed.