05/18/2012 7:00 am EST

Focus: OPTIONS

Josip Causic

A past example of an advanced double-diagonal option trade initiated by Josip Causic is used to more clearly illustrate the intricacies of this option strategy, which works best in sideways conditions.

This more advanced article on double diagonals is a follow-up to yesterday’s article, which covered the basics of the double-diagonal option strategy.

In order to properly explain the topic of advanced double diagonals, an example of a live trade will be utilized. This trade was entered on Thursday, April 19, 2012, while \$XEO (the S&P 100 cash-settled index) was trading at \$629.59 and had the following goals:

1. Pay off some of the initial debit of placing the double diagonal with the sale of weekly options, and…
2. End up with some profit

Specifically, the goal was to accumulate at least 10% on the trade. For the sake of simplicity, this article will present a single spread. Figure 1 below lists the long legs, which were bought on the regular monthly options.

Click to Enlarge

As stated above, \$XEO was trading at \$629.59 at the time, and the purchase of both the May legs were out of the money (OTM), yet due to expiration being so many weeks out, the premium was expensive.

None of the premium value of the May 615 put or May 650 call was due to the intrinsic value. Knowing this fact, one might wonder, then, why would those OTM legs be purchased at all, especially at such a high cost of nearly \$1,000? (To be exact, \$960 was paid only for fluff, or time.)

The trading plan was aimed at selling weekly options against the long May (third-week expiry) options. So how many weeks of the weekly options could be sold against the long options?

Click to Enlarge

Figure 2 above points out that a total of four weeks could be sold, however, let us regurgitate the trading plan’s goals: buy the long OTM legs with the intention of selling the diagonal weekly OTM options for several weeks, reducing the initial debit and waiting for the opportunity to close the double diagonal for a profit. Once again, the goal was to get out as soon as these two objectives could be met.

The very first week, the following legs were sold: STO -1 Apr week D 645 call @ \$0.50, and STO – 1 Apr week D 620 put @ \$3.45, bringing in an aggregate of (\$3.45 + \$0.50) \$3.95, which reduced the cost of the entry to (\$9.60 – \$3.95) \$5.75. In other words, the cost of the initial double diagonal was lowered down to only \$575.

As soon as these short legs were filled, the orders to close them for a nickel were entered, and a week later (on Friday, April 27, 2012), these were filled.

The underlying \$XEO was trading at \$638, which was still in between the sold 645 call and 620 put. As soon as these were filled, the new cycle (May week A) of the 645c/620p was sold. The aggregate premium received from these two was \$2.10, which brought the debit down from \$5.75 (we added \$0.10 for buying back the two Apr week D legs for a nickel) to \$3.65.

These May week A sold legs also expired worthless because \$XEO closed on May 4, 2012 at \$622.73, again, within the 645/620 spread. Yet due to a significant drop near the sold 620 put, the opportunity presented itself to close the long May legs for a profit and terminate the trade.

Instead of selling the May week B options, the decision was made to exit. Selling the same 620 put and 645 call once again would have been risky.

On Monday, May 7, 2012, instead of dragging on the trade for another couple of weeks while \$XEO was trading dangerously near the \$620 level, the decision was made to close the long May 615 put (the filled price was \$4.05) as well as the long May 650 call. The long call, while it still had some value, received back only \$0.20, which together with the premium from the sale of the May 615 put, equals \$4.25.

Once that amount of \$4.25 gets subtracted from the leftover debit of \$3.65, we end up with the profit of \$0.60, which is exactly what was originally aimed at when the trade was entered on Thursday, April 19, 2012. This is at least a 10% rate of return on the initial investment of \$565 (\$0.60/\$5.65 = 10.6% rate of return).