June 30, 2011

All In the Family: Double Calendars vs. Double Diagonals

Filed under: Options Education — Tags: , — Dan Passarelli @ 9:39 am

Because it is the fancifully named winged beast category that garners the most attention, I thought today we could focus on the often overlooked members of the group: double calendars and double diagonals.

Double Calendars vs. Double Diagonals
Both double calendars and double diagonals have the same fundamental structure; each is short option contracts in

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nearby months and long option contracts in farther out months in equal numbers. As implied by the name, this complex spread is comprised of two different spreads. These time spreads (aka known as horizontal spreads and calendar spreads) occur at two different strike prices. Each of the two individual spreads, in both the double calendar and the double diagonal, is constructed entirely of puts or calls. But the either position can be constructed of puts, calls, or both puts and calls. The structure for each of both double calendars or double diagonals thus consists of four different, two long and two

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short, options. These spreads are commonly traded as “long double calendars” and “long double diagonals” in which the long-term options in the spread (those with greater value) are purchased, and the short-term ones are sold. The profit engine that drives both the long double calendar and the long double diagonal is the differential decay of extrinsic (time) premium between shorter dated and longer dated options

The structural difference between double calendars and double diagonals is the placement of the long strikes. In the case of double calendars, the strikes of the short and long contracts are identical. In a double diagonal, the strikes of the long contracts are placed farther OTM than the short strikes.

Why should I complicate my life with these two similar structures? The raison d’être of the double calendars and double diagonals is the position response to changes in IV; in optionspeak, the vega of the position. Both trades are vega positive, theta positive, and delta neutral—presuming the price of the underlying lies between the two middle strike prices—over the range of profitability. However, the double calendar positions, because of placement of the long strikes closer to ATM responds favorably more rapidly to increases in IV while the double diagonal responds more slowly. Conversely, decreases in IV of the long positions impacts negatively double calendars more strongly than it does double diagonals.

In future missives, nuances of strike selection and dynamic position management in the potential convulsions of market gyrations will be discussed. In addition, the other family members will be introduced and guidelines will be discussed to help the trader select amongst these close relatives when considering trades.

June 16, 2011

All In The Family

Filed under: Options Education — Tags: , , — Dan Passarelli @ 9:29 am

For the new options trader one of the most overwhelming concepts is the wide variety of choices of trade structures available in the new world into which he has entered. The world of stock trading is defined by only two initial choices when considering a trade: short or long. The world of options

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has many more choices when initiating a trade and each option trade is most profitably defined not only in terms of price but also implied volatility and time.While description of each and every type of option trade is well beyond the scope of a brief discussion such as this, it is helpful to

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focus on the various families of option trades in order to begin to become familiar with the unique characteristics of each member. One of the most frequently discussed types of trades can be described as those that are profitable over a wide range of prices of the underlying. This group of trades finds its basic family identity in the shape of the P/L curve as well as in the signature family blood type of theta positive.As in any diverse family, there is a wide variety of individual characteristics. The names of the individual strategies within this family is numerous, often duplicative, and frequently confusing. One subgroup of these range bound strategies is flamboyantly named as winged beasts: condor, iron condor, butterfly, iron butterfly, and split strike butterfly. Another less colorfully named branch of the family is that of the double calendar and double diagonal. The structure of each of these trades has a characteristic skeletal framework, but within these defining limits, the latitude in fine structural details is broad.

June 10, 2011

Trading Option Strangles 101

We have discussed the straddle options strategy in the past, a strategy that traders can use when the market is volatile but direction is uncertain. Another play similar to the straddle is the option strangle. In a straddle, the investor is betting on both sides of a trade by purchasing options with the same strike price and the same expiration date, on the same underlying. A trader can create a similar trade, but with a lower price by trading a strangle instead. Rather than purchasing a put and a call at the same strike (as in the straddle), the investor purchases a put and a call at different strikes, still with the same expiration. By using a put and a call that are out-of-the-money, a trader pays a lower initial premium. However, this comes

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with a caveat – the stock will have to make a much larger move than it would if a straddle were employed. The investor is, arguably, taking a larger risk (because a bigger move is needed than with a straddle), but is paying a lower price.

The Particulars
Like a straddle, a strangle has two breakeven points. To calculate these points simply add the net premium (call premium + put premium) to the strike price of the call (for upside breakeven) and subtract the net premium from the put’s strike (to calculate downside breakeven). If at expiration, the stock has advanced or dropped past one of these breakevens, the profit potential of the strategy is unlimited (yes, unlimited). The position will take a 100% loss if the stock is trading between the put and call strikes upon expiration. Remember that the maximum loss an investor can take on a strangle is the net premium paid.

Example Trade
To create a strangle, a trader will purchase one out-of-the-money (OTM) call and one OTM put. In this example, the trader would buy both a July

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52.50 call and an July 50 put. For simplicity, we will assign a price of $1.00 (rounded up for the call and down for the put) for both – resulting in an initial investment of two bucks for our investor (which is the maximum potential loss).

Should the stock rally past $52.50 at expiration, the 50 put expires worthless and the $52.50 call expires in-the-money (ITM) resulting in the strangle trader collecting on the position. If, for example, the intrinsic value of the call at expiration is $6, the profit is $4 (intrinsic value less the premium paid). The same holds true if the stock falls below $50 at expiration, it then is the put that is ITM and the call expires worthless. The danger is that the stock moves nowhere by the time option expiration occurs. In this case, both legs of the position expire worthless and the initial two dollars, or $200 of actual cash, is lost.

Notice that the maximum loss is the initial premium paid, setting a nice limit to potential losses. Potential profits on the strangle are unlimited.

June 1, 2011

Option Trading System

Looking for an option trading system? Let the Market Taker Mentoring Trading Path be your options trading guide.

The MTM Trading Path
The MTM Trading Path is a simple, but powerful proprietary option trading system designed to be a

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veritable options trading guide that outlines a step-by-step a plan for options trading. There are a total of eleven steps in this options trading

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system which begins with observing the market and discovering opportunities.

Options trading is, of course, more involved than stock trading. Specifically, there are two steps in this options trading guide that are not in a conventional trading plan. These steps center around analyzing volatility and selecting among the various strategies.

The important thing here is discipline. Having a guide to follow to avoid missing important steps is the key to any options trading plan. The Trading Path is central to my Options Coaching program and my Online Options Education Series. I encourage my options coaching students and students in my options seminars alike to closely follow this option trading guide for all their trades.

For more information on the Market Taker Mentoring Trading Path, email me personally at dan@markettaker.com