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November 25, 2015

Option Strangle Anyone?

The market has been quite volatile over the past month or so. The S&P 500 started out the month trading above the 2,100 level and then fell to around the 2,020 level before rebounding again. With the Federal Reserve threatening to raise rates as early as next month and the continued threat of more terrorist activities around the globe, there is a decent opportunity that the markets may continue to be volatile. Let’s take a look at an option strategy that may be able to take advantage of this uncertain outlook.

An option strangle is an option strategy that option traders can use when they think there is an imminent move in the underlying but the direction is uncertain. With an option strangle, the trader is betting on both sides of a trade by purchasing a put and a call generally just out-of-the-money (OTM), but with the same expiration. By buying a put and a call that are OTM, an option trader pays a lower initial price than with an option straddle where the call and put purchased share the same strike price. However, this comes with a price so-to-speak; the stock will have to make a much larger move than if the option straddle were implemented because the breakeven points of the trade will be further out due to buying both options OTM. The trader is, arguably, taking a larger risk (because a bigger move is needed than with an option straddle), but is paying a lower price. Like many trade strategies there are pros and cons to each. If this or any other option strategy sounds a little overwhelming to you, I would invite you to checkout the Options Education section on our website.

The Particulars

An option strangle has two breakeven points just like the option straddle. 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 breakeven points, the profit potential of the strategy is unlimited (for upside moves). 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 a trader can take on an option strangle is the net premium paid.

Implied Volatility

The implied volatility (IV) of the options plays a key role in an option strangle as well. With no short options in this spread, the IV exposure is concentrated. When IV is considered low compared to historical volatility (HV), it is a relatively “cheap” time to buy options. Since the option strangle involves buying a call and put, buying “cheaper” options is critical. If the IV is expected to increase after the option strangle is initiated, this could increase the option premiums with all other factors held constant which is certainly a bonus for long option strangle holders.

Example Trade

To create an option strangle, a trader will purchase one out-of-the-money (OTM) call and one OTM put. An option trader may think Keurig Green Mountain Inc. (GMCR) looks good for a potential option strangle since at the time of this writing, the stock is trading around $48.60 after earnings this past week. With IV much lower than HV and the trader unsure in what direction the GMCR may move, the option strangle could be the way to go. The trader would buy both an January 50 call and a January 47.5 put. For simplicity, we will assign a price of 2.50 for both – resulting in an initial investment of $5 (2.50 + 2.50) for our trader (which again is the maximum potential loss).

Green Mountain Stock Rallies

Should GMCR rally past the call’s breakeven point which is $55 (50 + 5) at January expiration, the 47.5 put expires worthless and the $50 call expires in-the-money (ITM) resulting in the strangle trader collecting on the position. If, for example at expiration the stock is trading at $58 which means the intrinsic value of the call $8 (58 – 50), the profit is $3 (8 – 5) which represents the intrinsic value less the premium paid.

Green Mountain Stock Declines

The same holds true if the stock falls below the put’s breakeven point at expiration. The put is in ITM and the call expires worthless. At expiration, if GMCR is trading below the put’s breakeven point of the trade which is $42.50 (47.50 – 5), a profit will be realized. The danger is that GMCR finishes between $42.50 and $55 as expiration occurs. In this case, both legs of the position expire worthless and the initial 5, or $500 of actual cash, is lost.

Maximum Loss

Notice that the maximum loss is the initial premium paid, setting a nice limit to potential losses. Profits and losses can be realized way before expiration and it is up to the trader to decide how and when to close the position. Potential profits on the strangle are unlimited which can be very rewarding but as always, a traders needs to decide how he or she will manage the position. Consider managing the position for profit and loss based on a certain percentage or a certain number of days or both!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 29, 2015

Going for the Hail Mary with Call Options

When a football team is down in the closing seconds and the team has no alternatives but to heave up a desperation throw towards the end zone, it is often referred to as a “Hail Mary” pass. In other words, there is a slim chance that the play will work out. The funny thing about that is that option traders do the same all the time especially in earnings season when options have elevated premiums due to the pending announcement.

It seems like almost every other week and even more so during earnings that a student will ask me about buying deep out-of-the money (OTM) options. Many option traders, especially those that are new, initially buy deep out-of-the-money options because they are cheap and can offer a huge reward. Unfortunately, many times, these “cheap” options are rarely a bargain. Don’t get me wrong, at first glance an OTM call that costs $0.25 may seem like a steal.  But if the call’s strike price is say $20 or $30 (depending on the stock price) above the market and the stock has never rallied that much before even over an earnings announcement in the amount of time until expiration, the option will likely expire worthless or close to it.

Negative Factors

Many factors work against the success of a deep OTM call from profiting. The call’s delta (rate of change of an option relative to a change in the underlying) will typically be so small that even if the stock starts to rise, the call’s premium will not increase much. In addition, option traders will still have to overcome the bid-ask spread (the difference between the buy and sell price) which might be anywhere from $0.05 to $0.15 or even more for illiquid options.

Option traders that tend to buy the cheapest calls available are probably calls that have the shortest time left until expiration. If an OTM call option expires in less than thirty days, its time decay measured by theta (rate of change of an option given a unit change in time) will be often larger than the delta especially for higher priced and more volatile stocks. Any potential gains from the stock rising in price can be negated by the time decay. Plus each day the OTM call option premium will decrease if the stock drops, trades sideways or rallies just a tad.

Final Thoughts

A deep OTM call option can become profitable only if the stock unexpectedly jumps much higher. If the stock does rise sharply, an OTM call option can hit the proverbial homerun and post impressive gains. The question option traders need to ask themselves is how much are they willing to lose waiting for the stock to rise knowing that the odds are unlikely for it to happen in the first place? Trades like these have very low odds and may be better suited for the casino then the trading floor.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 1, 2015

How Option Delta and Gamma Influence Each Other

Not sure if you have noticed, but the market has been very volatile lately. Stocks have been moving in sometimes dramatic fashion on a daily basis so it might be wise to review how option prices change when the underlying changes. The option “greeks” help explain how and why option prices move. Option delta and option gamma are especially important because they can determine how movements in the stock can affect an option’s price. Let’s take a brief look at how they can affect each other.

Delta and Gamma

Option delta measures how much the theoretical value of an option will change if the stock moves up or down by $1. For example, if a call option is priced at 3.50 and has an option delta of 0.60 and the stock moves higher by $1, the call option should increase in price to 4.10 (3.50 + 0.60). Long calls have positive deltas meaning that if the stock gains value so does the option value all constants being equal. Long puts have negative deltas meaning that if the stock gains value the options value will decrease all constants being equal.

Option gamma is the rate of change of an option’s delta relative to a change in the stock. In other words, option gamma can determine the degree of delta move. For example, if a call option has an option delta of 0.40 and an option gamma of 0.10 and the stock moves higher by $1, the new delta would be 0.50 (0.40 + 0.10).

Think of it this way. If your option position has a large option gamma, its delta can approach 1.00 quicker than with a smaller gamma. This means it will take a shorter amount of time for the position to move in line with the stock. Stock has a delta of 1.00. Of course there are drawbacks to this as well. Large option gammas can cause the position to lose value quickly as expiration nears because the option delta can approach zero rapidly which in turn can lower the option premium. Generally options with greater deltas are more expensive compared to options with lower deltas.

ATM, ITM and OTM

Option gamma is usually highest for near-term and at-the-money (ATM) strike prices and it usually declines if the strike price moves more in-the-money (ITM) or out-of-the-money (OTM). As the stock moves up or down, option gamma drops in value because option delta may be either approaching 1.00 or zero. Because option gamma is based on how option delta moves, it decreases as option delta approaches its limits of either 1.00 or zero.

An Example

Here is a theoretical example. Assume an option trader owns a 30 strike call when the stock is at $30 and the option has one day left until expiration. In this case the option delta should be close to if not at 0.50. If the stock rises the option will be ITM and if it falls it will be OTM. It really has a 50/50 chance of being ITM or OTM with one day left until expiration.

If the stock moves up to $31 with one day left until expiration and is now ITM, then the option delta might be closer to 0.95 because the option has a very good chance of expiring ITM with only one day left until expiration. This would have made the option gamma for the 30 strike call 0.45.

Option delta not only moves as the stock moves but also for different expirations. Instead of only one day left until expiration let’s pretend there are now 30 days until expiration. This will change the option gamma because there is more uncertainty with more time until expiration on whether the option will expire ITM versus the expiration with only one day left. If the stock rose to $31 with 30 days left until expiration, the option delta might rise to 0.60 meaning the option gamma was 0.10. As discussed before in this blog, sometimes market makers will look at the option delta as the odds of the option expiring in the money. In this case, the option with 30 days left until expiration has a little less of a chance of expiring ITM versus the option with only one day left until expiration because of more time and uncertainty; thus a lower option delta.

Closing Thoughts

Option delta and option gamma are critical for option traders to understand particularly how they can affect each other and the position. A couple of the key components to analyze are if the strike prices are ATM, ITM or OTM and how much time there is left until expiration. An option trader can think of option delta as the rate of speed for the position and option gamma as how quickly it gets there.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.

March 4, 2015

A Butterfly Spread Used Directionally

For the most part,  option traders use butterfly spreads for a neutral outlook on the underlying. The position is structured to profit from time decay but with the added benefit of a “margin of error” around the position depending on what strike prices are chosen. Butterflies can be great market-neutral trades. However, what some traders don’t realize is that butterflies can also be great for trading directionally.

A Butterfly

The long butterfly spread involves selling two options at one strike and the purchasing options above and below equidistant from the sold strikes. This is usually implemented with all calls or all puts. The long options are referred to as the wings and the short options are the body; thus called a butterfly.

The trader’s objective for trading the long butterfly is for the stock to be trading at the body (short strikes) at expiration. The goal of the trade is to benefit from time decay as the stock moves closer to the short options strike price at expiration. The short options expire worthless or have lost significant value; and the lower strike call on a long call butterfly or higher strike put for a long put butterfly have intrinsic value. Maximum loss (cost of the spread) is achieved if the stock is trading at or below the lower (long) option strike or at or above the upper (long) option strike.

Directional Butterfly

What may not be obvious to novice traders is that butterfly spreads can be used directionally by moving the body (short options) of the butterfly out-of-the-money (OTM) and maybe using slightly wider strike prices for the wings (long options). This lets the trader make a directional forecast on the stock with a fairly large profit zone depending on the width of the wings.

To implement a directional butterfly, a trader needs to include both price and time in his outlook for the stock. This can be the most difficult part for either a neutral or directional butterfly; picking the time the stock will be trading in the profit zone. Sometimes the stock will reach the area too soon and sometimes not until after expiration. If the trader picks narrow wings (tighter strikes), he can lower the cost of the spread. If the trader desires a bigger profit zone (larger strikes), he can expand the wings of the spread and the breakevens but that also increases the cost of the trade. It’s a trade-off.

Final Thoughts

One of the biggest advantages of a directional butterfly spread is that it can be a relatively low risk and high reward strategy depending on how the spread is designed. Maybe one of the biggest disadvantages of a directional butterfly spread is that its maximum profit potential is reached close to expiration. But being patient can be very good for a trader…most of the time!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

November 25, 2014

Weekly Options and Theta

There are so many different characteristics of options that I talk a lot about with my options coaching students. But one of the more popular subjects is that premium sellers see the most dramatic erosion of the time value (option theta) of options they have sold during the last week of the options cycle. Most premium sellers strive to keep the options they have sold short (also known as options they have “written”) out-of-the-money (OTM) in order that the entirety of the premium they have sold represents time (extrinsic) premium and is subject to this rapid time decay.

With 12 monthly cycles, there historically have been only 12 of these final weeks per year in which premium sellers have seen the maximum benefit of their core strategy. The continued and expanding use of weekly options has changed the playing field. Options with one week durations are available on several indices and several hundred different stocks. These options have been in existence since October 2005 but only in the past couple of years have they gained widespread recognition and achieved sufficient trading volume to have good liquidity. Further now, there are even more weeklys that go for consecutive weeks (1 week options, 2 week options, 3 week options, 4 week options and 5 week options).

Standard trading strategies employed by premium sellers can be executed in these options. The advantage is to gain the “sweet spot” of the time decay of premium without having to wait through the entirety of the 4 to 5 week option cycle. In addition, it gives premium-selling option traders even more choices to take advantage of option theta. The party never ends for premium sellers using these innovative methods. Of course there is a trade-off because the shorter the time there is left until expiration, the smaller the option premiums are compared to an option with a longer expiration. As option traders, we are used to tradeoffs.

Option traders interested in using these weeklys MUST understand settlement procedures and be aware of last days for trading. An excellent discussion of weeklies given by Dan Passarelli is available at Learn to Trade Weeklys. enjoy the Holidays!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

November 13, 2014

Consider a Directional Butterfly

Many option traders use butterfly spreads for a neutral outlook on the underlying. The position is structured to profit from time decay but with the added benefit of a “margin of error” around the position depending on what strike prices are chosen. Butterflies can be great market-neutral trades. However, what some traders don’t realize is that butterflies can also be great for trading directionally.

A Butterfly

The long butterfly spread involves selling two options at one strike and the purchasing options above and below equidistant from the sold strikes. This is usually implemented with all calls or all puts. The long options are referred to as the wings and the short options are the body; thus called a butterfly.

The trader’s objective for trading the long butterfly is for the stock to be trading at the body (short strikes) at expiration. The goal of the trade is to benefit from time decay as the stock moves closer to the short options strike price at expiration. The short options expire worthless or have lost significant value; and the lower strike call on a long call butterfly or higher strike put for a long put butterfly have intrinsic value. Maximum loss (cost of the spread) is achieved if the stock is trading at or below the lower (long) option strike or at or above the upper (long) option strike.

Directional Butterfly

What may not be obvious to novice traders is that butterfly spreads can be used directionally by moving the body (short options) of the butterfly out-of-the-money (OTM) and maybe using slightly wider strike prices for the wings (long options). This lets the trader make a directional forecast on the stock with a fairly large profit zone depending on the width of the wings.

To implement a directional butterfly, a trader needs to include both price and time in his outlook for the stock. This can be the most difficult part for either a neutral or directional butterfly; picking the time the stock will be trading in the profit zone. Sometimes the stock will reach the area too soon and sometimes not until after expiration. If the trader picks narrow wings (tighter strikes), he can lower the cost of the spread. If the trader desires a bigger profit zone (larger strikes), he can expand the wings of the spread and the breakevens but that also increases the cost of the trade. It’s a trade-off.

Final Thoughts

One of the biggest advantages of a directional butterfly spread is that it can be a relatively low risk and high reward strategy depending on how the spread is designed. Maybe one of the biggest disadvantages of a directional butterfly spread is that its maximum profit potential is reached close to expiration. But being patient can be very good for a trader…most of the time!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 10, 2014

Option Delta and Option Gamma

The option “greeks” help explain how and why option prices move. Option delta and option gamma are especially important because they can determine how movements in the stock can affect an option’s price. Let’s take a brief look at how they can affect each other.

Delta and Gamma

Option delta measures how much the theoretical value of an option will change if the stock moves up or down by $1. For example, if a call option is priced at 3.50 and has an option delta of 0.60 and the stock moves higher by $1, the call option should increase in price to 4.10 (3.50 + 0.60). Long calls have positive deltas meaning that if the stock gains value so does the option value all constants being equal. Long puts have negative deltas meaning that if the stock gains value the options value will decrease all constants being equal.

Option gamma is the rate of change of an option’s delta relative to a change in the stock. In other words, option gamma can determine the degree of delta move. For example, if a call option has an option delta of 0.40 and an option gamma of 0.10 and the stock moves higher by $1, the new delta would be 0.50 (0.40 + 0.10).

Think of it this way. If your option position has a large option gamma, its delta can approach 1.00 quicker than with a smaller gamma. This means it will take a shorter amount of time for the position to move in line with the stock. Stock has a delta of 1.00. Of course there are drawbacks to this as well. Large option gammas can cause the position to lose value quickly as expiration nears because the option delta can approach zero rapidly which in turn can lower the option premium. Generally options with greater deltas are more expensive compared to options with lower deltas.

ATM, ITM and OTM

Option gamma is usually highest for near-term and at-the-money (ATM) strike prices and it usually declines if the strike price moves more in-the-money (ITM) or out-of-the-money (OTM). As the stock moves up or down, option gamma drops in value because option delta may be either approaching 1.00 or zero. Because option gamma is based on how option delta moves, it decreases as option delta approaches its limits of either 1.00 or zero.

An Example

Here is a theoretical example. Assume an option trader owns a 30 strike call when the stock is at $30 and the option has one day left until expiration. In this case the option delta should be close to if not at 0.50. If the stock rises the option will be ITM and if it falls it will be OTM. It really has a 50/50 chance of being ITM or OTM with one day left until expiration.

If the stock moves up to $31 with one day left until expiration and is now ITM, then the option delta might be closer to 0.95 because the option has a very good chance of expiring ITM with only one day left until expiration. This would have made the option gamma for the 30 strike call 0.45.

Option delta not only moves as the stock moves but also for different expirations. Instead of only one day left until expiration let’s pretend there are now 30 days until expiration. This will change the option gamma because there is more uncertainty with more time until expiration on whether the option will expire ITM versus the expiration with only one day left. If the stock rose to $31 with 30 days left until expiration, the option delta might rise to 0.60 meaning the option gamma was 0.10. As discussed before in this blog, sometimes market makers will look at the option delta as the odds of the option expiring in the money. In this case, the option with 30 days left until expiration has a little less of a chance of expiring ITM versus the option with only one day left until expiration because of more time and uncertainty; thus a lower option delta.

Closing Thoughts

Option delta and option gamma are critical for option traders to understand particularly how they can affect each other and the position. A couple of the key components to analyze are if the strike prices are ATM, ITM or OTM and how much time there is left until expiration. An option trader can think of option delta as the rate of speed for the position and option gamma as how quickly it gets there.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

June 18, 2014

AAPL Butterfly After the Split

There has been more talk than usual about Apple Inc. (AAPL) before and now just after the split. Several traders have asked me about what type of AAPL option trade they can use if they think AAPL will rise to around $100 in a few short weeks. Truth be told, there is more than one option strategy that can profit. But an option trader should consider a directional butterfly spread particularly if he or she has a particular time frame in mind as well. Depending on how the butterfly spread is structured, the option trader can structure a high risk/reward ratio for the spread. Let’s take a look at this option strategy.

The long butterfly spread involves selling two options at one strike and then purchasing options above and below equidistant from the sold strikes. This is usually implemented with all calls or all puts. The long options are considered to be the wings and the short options are the body of the butterfly. The option strategy objective is for the stock to be trading at the sold strikes at expiration. The option strategy benefits from time decay as the stock moves closer to the short options strike price at expiration. The short options expire worthless or have lost significant value and the lower strike call on a long call butterfly spread or higher strike put for a long put butterfly spread have intrinsic value.

As mentioned above, if an option trader thinks that AAPL will be trading around $100 in about three weeks, he can implement a long call butterfly spread with the sold strikes (body) right at $100. Put options could also be used but since the spread is being structured out-of-the-money (OTM), the bid/ask spreads of the options tend to be tighter versus in-the-money (ITM) options which would be the case with put options. The narrower the option trader makes the wings (long calls) the less the trade will cost but there will be less room to profit due to the breakevens. If the butterfly spread is designed with larger wings, the more it will cost but there will be a wider area between the breakevens.

At the time of this writing, AAPL is trading around $92. An option trader decides to buy a Jul-03 97/100/103 call butterfly for 0.15. The most the trader can lose is $0.15 if AAPL closes at or below $97 and at or above $103 at expiration. The breakevens on the trade are between $97.15 (97 + 0.15) and $102.85 (103 – 0.15). The maximum profit on the trade in the unlikely event AAPL closes exactly at $100 on expiration would be $2.85 (3 – 0.15). This gives this option strategy a 1 to 19 risk/reward ratio. Granted AAPL needs to move higher and be around $100 in three weeks but one could hardly argue about the risk/reward of the option strategy or the generous breakeven points of the spread.

This AAPL option trade may be a bit overwhelming for a new option trader to understand and there is more than one way to take a bite out of AAPL with a bullish bias. A directional call butterfly spread in this instance is just one way. A big advantage that the directional butterfly strategy may have over another option strategy is the high risk/reward ratio. The biggest disadvantage is the trader needs to be right about the time frame in which the stock will trading between the wings since maximum profit is earned as close to expiration as possible.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 15, 2014

Delta and Your Overall Position

Delta is probably the first greek an option trader learns and is focused on. In fact it can be a critical starting point when learning to trade options. Simply said, delta measures how much the theoretical value of an option will change if the stock moves up or down by $1. A positive delta means the position will rise in value if the stock rises and drop in value of the stock declines. A negative delta means the opposite. The value of the position will rise if the stock declines and drop in value if the stock rises in price. Some traders use delta as an estimate of the likelihood of an option expiring in-the-money (ITM). Though this is common practice, it is not a mathematically accurate representation.

The delta of a single call can range anywhere from 0 to 1.00 and the delta of a single put can range from 0 to -1.00. Generally at-the-money (ATM) options have a delta close to 0.50 for a long call and -0.50 for a long put. If a long call has a delta of 0.50 and the underlying stock moves higher by a dollar, the option premium should increase by $0.50. As you might have derived, long calls have a positive delta and long puts have a negative delta. Just the opposite is true with short options—a short call has a negative delta and a short put has a positive delta. The closer the option’s delta is to 1.00 or -1.00 the more it responds closer to the movement of the stock. Stock has a delta of 1.00 for a long position and -1.00 for a short position.

Taking the above paragraph into context one may be able to derive that the delta of an option depends a great deal on the price of the stock relative to the strike price of the option. All other factors being held constant, when the stock price changes, the delta changes too.

An important thing to understand is that delta is cumulative. A trader can add, subtract and multiply deltas to calculate the delta of the overall position including stock. The overall position delta is a great way to determine the risk/reward of the position. Let’s take a look at a couple of examples.

Let’s say a trader has a bullish outlook on Apple (AAPL) when the stock is trading at $590 and purchases 3 June 590 call options. Each call contract has a delta of +0.50. The total delta of the position would then be +1.50 (3 X 0.50) and not 0.50. For every dollar AAPL rises all factors being held constant again, the position should profit $150 (100 X 1 X 1.50). If AAPL falls $2, the position should lose $300 (100 X -2 X 1.50).

Using AAPL once again as the example, lets say a trader decides to purchase a 590/600 bull call spread instead of the long calls. The delta of the long $590 call is once again 0.50 and the delta of the short $600 call is -0.40. The overall delta of the position is 0.10 (0.50 – 0.40). If AAPL moves higher by $5, the position will now gain $50 (100 X 5 X 0.10). If AAPL falls a dollar, the position will suffer a $10 (100 X -1 X 0.10) loss.

Calculating the position delta is critical for understanding the potential risk/reward of a trader’s position and also of his or her total portfolio as well. If a trader’s portfolio delta is large (positive or negative), then the overall market performance will have a strong impact on the traders profit or loss.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

 

 

April 10, 2014

Double Your Pleasure

With earnings season just kicking off once again, it might be a good time to talk about a subject that is brought up quite often in MTM Group Coaching and Online Education 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 expirations and long option contracts in farther out expirations 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 main 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 out-of-the-money) OTM than the short strikes.

Why should an option trader complicate his or her life with these two similar structures? The reason traders implement 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 writings, the selection of strike prices and 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 and alternatives.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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