Making the Most of Your Options

The trader from the previous example had a time-spread alternative to the diagonal: John could have simply bought a traditional time spread at the 420 strike.Recall that calendars reap the maximum reward when they are at the shared strike price at expiration of the short-term option.The diagonal in that example uses a lower-strike call in the February than a straight 420 calendar spread and therefore has a higher delta, but it costs more.

Gamma, theta, and vega may be slightly lower with the in-themoney call, depending on how far from the strike price the ITM call is and 230 Spreads how much time until expiration it has. These, however, are less relevant differences.The delta of the February 400 call is about 0.57. The February 420 call,however, has only a 0.39 delta.

The 0.18 delta difference between the calls means the position delta of the time spread will be only about 0.07 instead of about 0.25 of the diagonal—a big difference. But the trade-off for lower delta is that the February 420 call can be bought for 12.15. That means a lower debit paid—that means less at risk. Conversely, though there is greater risk with the diagonal, the bigger delta provides a bigger payoff if the trader is right.

Double Diagonals:A double diagonal spread is the simultaneous trading of two diagonal spreads: one call spread and one put spread. The distance between the strikes is the same in both diagonals, and both have the same two expiration months. Usually, the two long-term options are more out-of-the-money than the two shorter-term options. For exampleBuy 1 XYZ May 70 putSell 1 XYZ March 75 put Sell 1 XYZ March 85 call Buy 1 XYZ May 90 call

Like many option strategies, the double diagonal can be looked at from a number of angles. Certainly, this is a trade composed of two diagonal spreads—the MarchMay 7075 put and the MarchMay 8590 call. It is also two strangles—buying the May 7090 strangle and selling the March 7585 strangle. One insightful way to look at this spread is as an iron condor in which the guts are March options and the wings are May options.

Trading a double diagonal like this one, rather than a typically positioned iron condor, can offer a few advantages. The first advantage, of course, is theta. Selling short-term options and buying long-term options helps the trader reap higher rates of decay. Theta is the raison d’eˆtre of the iron condor. A second advantage is rolling. If the underlying asset stays in a range for a long period of time, the short strangle can be rolled month after month.

There may, in some cases, also be volatility-term-structure discrepancies on which to capitalize.A trader, Paul, is studying JPMorgan (JPM). The current stock price is $49.85. In this example, JPMorgan has been trading in a pretty tight range over the past few months. Paul believes it will continue to do so over the next month. Paul considers the following trade:Buy 10 September 55 calls at 0.30 — 19% IV Sell 10 August 52.50 call at 0.40 — 20.5% IV Sell 10

August 47.50 put at 0.50 — 24.4% IV Buy 10 September 45 put at 0.45 — 26% IV Net Credit 0.15 Paul considers volatility. In this example, the JPMorgan ATM call, the August 50 (which is not shown here), is trading at 22.9 percent implied volatility. This is in line with the 20-day historical volatility, which is 23 percent. The August IV appears to be reasonably in line with the September volatility, after accounting for vertical skew.

The IV of the August 52.50 calls is 1.5 points above that of the September 55 calls and the August 47.50 put IV is 1.6 points below the September 45 put IV. It appears that neither month’s volatility is cheap or expensive.Exhibit 11.12 shows the trade’s greeks.The analytics of this trade are similar to those of an iron condor.Immediate directional risk is almost nonexistent, as indicated by the delta.

But gamma and theta are high, even higher than they would be if this were a straight September iron condor, although not as high as if this were an August iron condor.Vega is positive. Surely, if this were an August or a September iron condor, vega would be negative. In this example, Paul is indifferent as to whether vega is positive or negative because IV is fairly priced in terms of historical volatility and term structure.

In fact, to play it close to the vest,Paul probably wants the smallest vega possible, in case of an IV move.Why take on the risk?The motivation for Paul’s double diagonal was purely theta. The volatilities were all in line. And this one-month spread can’t be rolled. If Paul were interested in rolling, he could have purchased longer-term options. But if he is anticipating a sideways market for only the next month and feels that volatility could pick up after that, the one-month play is the way to go.