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February 28, 2013

Double Calendars vs. Double Diagonals

Today we will talk about a subject that is brought up quite often in MTM Group Coaching and is often debated by option traders learning to trade advanced strategies; double calendars vs. double diagonals.

Double Calendars vs. Double Diagonals
Both double calendars and double diagonals have the same fundamental structure; each is short option contracts in 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 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 an option trader complicate his or her life with these two similar structures? The reason of existence of the double calendars and double diagonals is the position response to changes in IV; in optionspeak,

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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 blogs, nuances of strike selection and dynamic position management based on the volatility of the stock will be discussed. In addition, other option strategies will be introduced and guidelines will be discussed to help the trader select among these similar strategies when considering trades.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

February 21, 2013

Expiration Week: Butterflies

One of the major differences when learning to trade

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options as opposed to equity trading is the impact of time on the various trade vehicles. Remember that quoted option premiums reflect the sum of both intrinsic (if any) and extrinsic (time) value. Also remember that while very few things in trading are for certain, one certainty is that the time value of an option premium goes to zero at the closing bell on expiration Friday.

While this decay of time premium to a value of zero is reliable and inescapable in our world of option trading, it is important to recognize that the decay is not linear. It is during the final weeks of the option cycle that decay of the extrinsic premium begins inexorably to race ever faster to oblivion. In the vocabulary of the options trader, the rate of theta decay increases as expiration approaches. It is from this quickening of the pace that many examples of option trading vehicles gain their maximum profitability during this final week of their life.

Some of the most dramatic changes in behavior can be seen in the trading vehicle known as the butterfly. For those new to options, consideration of the butterfly represents the move from simple single legged strategy such as simply buying a put or a call to multi-legged strategies that include both buying and selling options in certain patterns.

To review briefly, a butterfly consists of a vertical debit spread and vertical credit spread sharing the central strike price constructed together in the same underlying in the same month. It may be built using either puts or calls and its directional bias derives from strike selection rather than the particular type of option used for construction. For a (long) butterfly, maximum profit is always achieved at expiration when the underlying closes at the short strike shared by the two vertical spreads.

The butterfly has the interesting functional characteristic that it responds sluggishly to price movement early in its life, for example in the first two weeks of a four week option cycle. However, as expiration approaches, the butterfly becomes increasingly sensitive to price movement as the time premium erodes and the beast becomes increasingly subject to delta as a result of increasing gamma. It is for this reason that many butterfly traders restrict their use to the more responsive part of the options cycle. For a butterfly, the greatest sensitivity to time (and, therefore, profit potential) is reaped in the final week of the life cycle of the butterfly, i.e. expiration week.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

February 14, 2013

Baseball, Buying a Car and Iron Condors

With spring training right around the corner, traders should ask themselves this question; have you ever noticed a baseball player warming up before a game? Or watched footage of a baseball player at practice? What are they doing? Swinging a bat. Throwing and catching balls. Running bases. Working on the fundamentals. To be good at anything requires learning the fundamentals and constantly working on them throughout your career.

Option trading is no different. Even traders who have traded for years, who trade complex strategies return to the fundamentals to make their trading decisions. Take trading iron condors. Trading iron condors requires utilizing the fundamentals. Traders who are trading iron condors are trading a fairly complex, four-legged option strategy. They need to be able to visualize the strategy in order to analyze it and ultimately decide whether or not they should be trading iron condors or something else.

Traders trading iron condors should consider the spread from several different perspectives. Specifically, they should consider it as combinations of other spreads. When a trader is trading iron condors, the trader is in fact trading a pair of credit spreads. An iron condor is a put credit spread combined with a call credit spread. That’s one way to look at it.

Trading iron condors can also be considered from the strangle-trading perspective. An iron condor is a short strangle combined with a long strangle with wider strikes. The profit (and risk) comes from the short strangle, while the long one provides protection.

An iron condor can also be thought of as four individual option positions. Traders trading iron condors have a position in a long put, in a short put, in a short call and in a long call. Thinking of trading iron condors from this perspective, in particular, can help traders make adjustment and closing decision more effectively.

And, of course, an iron condor is, well, an iron condor! It is a single strategy in which the risk can be observed on a P&(L) diagram or through the greeks.

This strategy-break-down technique is not just suited for trading iron condors, but for trading all multi-legged strategies. It is an effective analysis technique akin to how car shoppers consider buying a car. They look at the front; then walk around to the side, then the back; they look under the hood and at the interior. All the while, they are considering this one purchase, but just from many different perspectives.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

February 7, 2013

Stop AAPL in Time

Learning to trade options offers a number of unique advantages to the trader, but perhaps the single most attractive characteristic is the ability to control risk precisely and to do so with precision. Much of this advantage derives from the ability to control positions equivalent to stock with far less capital commitment.

However, a less frequently discussed aspect of risk control is the ability to moderate risk by the astute use of time stops as well as the more familiar price stops more generally known to traders. Because time stops take advantage of the time decay of extrinsic premium to help control risk, it is important to recognize that this time decay is not linear.

As a direct result, it is not obviously apparent the time course that the decay curve will follow. An option trader has to take into account that the option modeling software is essential to plan the trade and decide the appropriate date at which to place a time stop.

As a simple example, consider the case of a short position in AAPL established by buying in-the-money March 470 puts. A trader could establish a position consisting of 10 long contracts with a position delta of -595 for approximately $22,000 as I write this.

At the time of this writing, the stock is trading around $459; these puts are therefore $11 in-the-money. Let’s assume a trader analyzes the trade with an at-expiration P&(L) diagram and wants to exit the trade as a stop loss if AAPL is at or above $462 at expiration. The options expiration risk is $14,000 or more. However, if the trader takes the position that the expected/feared move will occur quickly—long before expiration—he could

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implement a time stop as well.

Using a stop to close the position if the stock gets to $462 at a point in time around halfway to expiration would reduce the risk significantly. Because the option would still have some time value, the trader could sell the option for a loss prior to expiration, therefore retaining some time value and fetch a higher price. In this event, closing prior to expiration helps the trader lose less when the stop executes, especially if there is a fair amount of time until expiration and time decay hasn’t totally eroded away.

Options offer a variety of ways to control risk. Learn and use all risk control maneuvers available; life is a risky business.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring