How to Manage a Double Diagonal Option Spread Trade

08/02/2010 10:52 am EST

Focus: OPTIONS

Mark Wolfinger

Educator, MDWoptions

As noted, when trading double diagonal spreads, the enemy is a significant market move. When your short options move in the money (ITM), or threaten to move ITM, the position begins to lose money. That gives the trader two main choices.

The first choice is to do nothing and hope the market reverses direction, or that expiration day arrives before too much damage is done. This is a very poor choice, yet it’s a popular one. Why? It’s often the result of traders not knowing what action to take, coupled with the idea of being forced to close the position and accept a loss. Avoiding a loss is the mantra for such traders. This is a dangerous path to follow because losses, although limited, can become large enough to threaten your ability to continue trading.

The second and more effective choice is to take action that reduces position risk and increases the trader’s chances of earning money going forward. Of course, it’s every trader’s goal to earn money, but holding a position with the hope of recovering a loss and eventually breaking even is not a sound policy. It’s far more effective to exit a bad trade and only hold positions that you believe are worth holding—and that includes positions with a good risk/reward profile.

Let’s examine a double diagonal spread that is in trouble and consider some alternatives.

You have this position:
Long 10 INDX March 930 calls
Short 10 INDX February 900 calls

Long INDX March 720 puts
Short INDX February 750 puts

This position was built by selling a call spread and a put spread, but the long option expires one month later than the short option. When INDX moves enough to approach either $750 or $900, this position is almost always losing money. 
If you still hold the position as expiration nears, then the position may be profitable as INDX approaches one of the strikes. However, as with other negative gamma trades, this position has suddenly been transformed into a high-risk/high-reward gamble. Positions in which a trader is short front-month options become very dangerous when expiration is only a few days in the future. Prudent risk management tells the trader to exit before being in that situation. However, as much as I preach that idea, it’s understood that many traders prefer the excitement of collecting that rapid time decay while ignoring risk.

Unlike an iron condor, in which your long options are too far out of the money (OTM) to be helpful (except to serve their primary purpose, which is to limit losses), with a diagonal position, the long option is very much alive. That’s why there may be a profit when the short option is almost at the money (ATM).

Depending on how far OTM that long option is, and depending on implied volatility levels, this risky situation (near expiration with shorts almost ATM) can show a profit. That should be all the incentive a trader needs to exit the dangerous trade.

In my opinion, whether it’s a profit or loss does not matter. If the position is too risky to hold, then it’s just that—too risky to hold—and must be closed. Once again, many traders consider only profit/loss.

Note: A continued move in the same direction may result in the short option smashing through the strike price with position deltas quickly moving against you. What appears to be a perfect finish (arrival at expiration) can become an instant nightmare.

NEXT: A Look at Risk Management Techniques

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Risk Management Techniques

It’s tempting to hold positions all the way through expiration, because when the front-month options expire worthless, good-sized profits may be there for the taking. The conflict is that exiting prior to expiration reduces risk, and for long-term success, less risk is the name of the game. If you cannot stand giving up the chance to earn a large profit, then consider scaling out of the trade, closing a small portion every day as expiration nears.

When the underlying (INDX, an imaginary index, in this example) is approaching the strike price, be ready with a plan made in advance. It’s best to write a trade plan that includes: “I’ll take this protective action if INDX trades at that price.”
At (or before) the first sign of discomfort, make an adjustment to reduce risk, such as:

1. Close a portion of the trade, perhaps 10% to 20%
2. Buy protection with options or spreads

Important: If buying front-month options, protection must be less OTM than the current short option. The rationale for buying front-month options is that they are less expensive than second month options. When buying insurance, cost must be considered. 

Example: For the double diagonal spread above, if upside protection is needed, consider buying:

  • February 880 or February 890 calls for more protection
  • February call spreads: 880/890 or 890/900 for less costly, but limited, protection

Any trade that adds positive delta helps in this scenario (negative delta is needed if the put spread is in trouble). If it adds positive gamma, it’s even better because it makes additional market advances less painful.

When you can fix a position so that it remains within your comfort zone, that is often a better plan than closing the trade. However, please understand there is a huge difference between making an adjustment that allows you to feel comfortable owning the position and forcing an adjustment, hating the position, and desperately trying to recover losses. The latter is the mindset of the trader who is not destined to survive as a trader. Exercise sound risk management and you can plan on enjoying a lengthy trading career.

By Mark Wolfinger of Options For Rookies

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