Deciding how much risk to take is an individual matter. For those who prefer to make a consistent profit regardless of the market trends, non-directional index option trading makes perfect sense. This reliable trading strategy eliminates those lumps in the stomach that come from trying to guess which way the market will go. The formula behind non-directional index option trading delivers consistent profit even during a dismal economy: you make money whether the market goes up, goes down, or holds the line.
The stock market, on the other hand, forces you to rely on guesses, gut feelings, and potentially bad advice when you make a trade. When you buy stock on a hunch and it goes up, that's great. But if it goes down, there goes your money. Non-directional index option trading takes away that gnawing in your gut borne of indecision, letting you sleep better as you make safe decisions.
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There are 4 index option markets we trade, as we seek high liquidity in European style options, & tight spreads:
S&P 500 (SPX), Russell 2000 (RUT), Nasdaq 100 (NDX) & S&P 100 (XEO).
Our preferred market is the RUT.
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The Greeks (Delta, Gamma, Theta, Vega & Rho) are important to understand when we trade index options. Think of the Greeks like the gauges in a car - we have a speedo to tell us how fast we are going. A fuel gauge to tell us how much further we can drive before we have to get more fuel. A temperature gauge will tell us if our engine will overheat and we need to stop. With index options, the Greeks are our gauges that tell us what will happen to the price of our options when certain market factors change. Read more about the Greeks, here.
Volatility is a key factor to understand when trading options because it has a key role in determining the price of options. There are 2 types of volatility ... Historical Volatility and Implied Volatility. Volatility allows us to calculate a standard deviation. The standard deviation becomes a gauge to understand and to evaluate price changes. Please refer to our volatility page for more information.
Detailed below are our 4 strategies:
Iron Condor Strategy
An Iron Condor is the simultaneous selling of an OTM (out of the money) put and call option, and the purchase of further OTM put & call options for risk management, all with the same expiration month. This strategy is great for investors and traders that want to make a consistent profit of 3% to 5% per month.
Let's take a fictitious company AcmePlus as an example. AcmePlus stock is currently trading at $100 per share, and we know that the price of AcmePlus never varies more than $1 or $2 up or down. We can Sell the 110 CALL Strike for the Expiration next month for $1.00 per share. Based on the price movements of AcmePlus, we feel very confident that the Market price of AcmePlus will not reach $110 by next month at Expiration. However, when we sell this CALL Option that we don't own, that is called selling 'Naked', which puts us at almost unlimited risk if the price of AcmePlus shoots up. So, to limit how much loss we are exposed to, we can Buy the 115 CALL strike for $0.40 per share. [Remember that Options Contracts represent 100 shares of stock.]
When we Sell 1 CONTRACT of the 110 CALL Strike for $1.00, we will get paid $100 immediately into our Brokerage account. (We sold the 110 CALL for $1.00 PER SHARE, and there are 100 shares in 1 CONTRACT = $100.)
When we Buy 1 CONTRACT of the 115 CALL Strike for $0.40, we will have to pay $40 immediately to cover that purchase. (We bought the 115 CALL for $0.40 PER SHARE, and there are 100 shares in 1 CONTRACT = $40.)
Our Gross Profit = $60. (We received $100 for the sale of the 1 CONTRACT 110 CALL Strike, and we paid $40 for the 1 CONTRACT 115 CALL Strike: $100 - $40 = $60.)
The maximum possible gross loss is $500. This is what would happen if the Market price of AcmePlus was above $115 at the Expiration of our Options next month. For example: If the price of AcmePlus was $116 at Expiration, then we would owe $600 on the 1 CONTRACT 110 CALL Strike we sold ($116 Expiration Price MINUS 110 CALL Strike = $6.00 per share x 100 shares in 1 CONTRACT = $600 owed.) However, we would receive $100 on the 1 CONTRACT 115 CALL Strike we bought ($116 Expiration Price MINUS 115 CALL Strike = $1.00 per share x 100 shares in 1 CONTRACT = $100 we receive as profit.). The Net result is that we would have a loss of $500.
However, we received $60 profit originally when we made this trade as a "premium" for the risk we were willing to take. So, even in the case of a complete and very unlikely loss, our NET LOSS would be $440. ($500 gross loss MINUS $60 profit on original trade = $440 Net Loss.). However, that was the worst case scenario, and it was one that was not likely to happen based on our evaluation of the price movements of AcmePlus. We had $500 at risk, and we made $60 = 12% return on our Investment. For those math wizards, it is true that our Net risk was only $440, and that our rate of return on the Net risk was actually 13.6%. However, when we trade Options, there are Commission expenses which lower the rate of return. In order to show more realistic profit returns, we calculate returns based on the gross profits.
SPREAD TRADES
When we trade Options, we don't have to go through the process of buying and selling the individual options of our Condor or other spread trades. We can make a "spread" order where we specify what options we want to buy and sell, and we can say what net amount we want to get. In our example above, we can put in a limit spread order to sell 1 contract of the 110 call strike and buy 1 contract of the 115 call strike, and we want a net credit of at least $0.60 per share. We then leave the pricing of the individual strikes of our position up to the market makers, as long as they give us a net credit of $0.60 per share. Using a spread order also protects us against any unfavorable changes in the underlying market price. We don't have to be in a rush to try to fill part of our order with a spread order. With spread orders, we either get the pricing we want or we can walk away.
COST & MARGIN REQUIREMENTS
Iron Condor's generate a credit spread - we get paid a credit into our brokerage account as soon as we make the trade. Our Broker will hold in 'maintenance' the maximum loss possible from this trade. The 'maintenance' money stays in our account, but we cannot trade against it while it is acting as the deposit for our Iron Condor trade. With both a put spread and a call spread on the same underlying, with the same expiration, most brokers will only hold 'maintenance' on the Iron Condor trade for one side of the trade, the side with the greatest possible loss. The reason is, at expiration, both sides cannot have a loss; either both sides are profitable, or one side has a loss.
TWO TYPES OF IRON CONDOR TRADES
We categorise potential Iron Condor trades into 2 categories: High Probability Iron Condors and Low Probability Iron Condors. For advanced traders, a Low Probability Iron Condor is made much closer to the current market price of the underlying, so it has a lower probability of success, but a much higher reward. A High Probability Iron Condor is made far away from the current market price of the underlying, so it has a high probability of success.
High Probability Iron Condors are probably the easiest type of options trade to understand and manage - orders that are easy to place and simple to monitor when we are in a position. It is also not difficult to set conditional orders to exit if the market makes some unusual price movements. It is possible to do a Super High Probability Iron Condor, which is a variation of the High Probability Iron Condor. In a Super High Probability Iron Condor, the delta of the short strike should be 4 or less, with a standard deviation of over 2 away from the underlying, and a minimum premium of 2% per side. These positions are not adjusted and are held even if the market hits the short strike. There is only a minute chance that the market will move that much and stay at that point by expiration. This trade can be done consistently, but a loss on this type of trade can mean a complete loss of funds at risk.
Low Probability Iron Condors are for seasoned traders. While they are technically the same type of trade as a High Probability Iron Condor, the Low Probability Iron Condor requires a diligent eye to monitor and adjust the position as the market price fluctuates.
HOW WE PROFIT
High Probability: we profit on a High Probability Iron Condor when the options reach expiration and they expire worthless, meaning that the underlying price never reached our exit points and we were able to hold these options positions until expiration. When the options expire worthless, we get to keep all the premium that we originally took in and now our maintenance money will be released so we can go make another trade.
Low Probability: we profit on a Low Probability Iron Condor through the reduction of the time premium of our options. We will hold the Low Probability Iron Condor for around 17 days, and as long as the underlying price does not reach our exit points, we will be able to close our position at a much smaller cost than when we entered the trade. For exanple, we might have taken in an initial credit of $250, and after 17 days, we might be able to close those positions for only $125, leaving us with a profit of $125 for our efforts.
HOW WE CAN HAVE A LOSS
A loss can occur when the underlying has unusual price movements in one direction that force us to remove our positions early.
PROBABILITIES
High Probability Iron Condors have probabilities of success generally over 90%
Low Probability Iron Condors have probabilities of success around 70% to 80%.
IRON CONDOR EXAMPLE:
The current price of AcmePlus stock is $100 per share.
CALL Condor
We SELL 1 Contract | ACMEPLUS | JUNE | 110 | CALL | $1.00 per share | Delta = .07
We BUY 1 Contract | ACMEPLUS | JUNE | 115 | CALL | $0.40 per share | (The Delta of the Long position is not a significant factor on a Condor; we only look at the Delta of the Short position.)
GROSS CREDIT = $60.00 ($0.60 per share)
MAINTENANCE = $500
PUT Condor
We SELL 1 Contract | ACMEPLUS | JUNE | 90 | PUT | $1.10 per share | Delta = .08
We BUY 1 Contract | ACMEPLUS | JUNE | 85 | PUT | $0.45 per share | (Recall that the Delta of the Long position is not a significant factor on a Condor.)
GROSS CREDIT = $65.00 ($0.65 per share)
MAINTENANCE = $500
IRON CONDOR TOTAL: (CALL CONDOR + PUT CONDOR)
GROSS CREDIT = $125.00 [$60.00 CALL CONDOR + $65.00 PUT CONDOR]
MAINTENANCE = $500 (Remember that most Brokers only take Maintenance on one side of a Condor, because we can't be wrong on both sides at Expiration.)
HIGH PROBABILITY IRON CONDOR TRADE RULES
SHORT POSITION
Is far out of the money, with a Delta of +/-0.05 to +/-0.09 ... in other words, the strike has between a 5% and a 9% probability of being ITM at expiration.
TIME FACTORS:
Time to Enter Trade: 55 days until 35 days prior to expiration
Preferred Time to Enter Trade: 49 days or 39 days prior to expiration
Minimum Time Premium: N/A
Earnings and News: N/A
Time In Trade: Held until Expiration
VOLATILITY FACTORS:
Maximum IV: N/A
IV Range: N/A
IV Channeling: N/A
IV Trend UP: OK
IV Trend DOWN: Only bad if it's fast.
IV Skew Range: N/A
VIX: stay out if VIX has posted a fresh 6 week high today, or in the prior 4 trading days. Stay out if VIX has has a +20% upward daily move in last 10 trading days. If 6 week high printed today, if in trade, get out today if a Friday, otherwise exit the next day only if close prints as a fresh 6 week high.
VIX: prefer to enter puts on/ or straight after a day that is up equal to or greater than 5%, and calls on/ or straight after a day that is down equal to or greater than 5%
PRICE FACTORS:
Minimum Underlying Price: only enter on/ or straight after a day that is down equal to or greater than 0.5%
Minimum Premium: $0.40 for 5 point spreads, $0.60 for 10 point spreads, $0.80 for 20 - 25 point spreads, $1.00 for 30 + point spreads.
Price Movements In Last Week: no greater than 5%
Price Movements in Last Month: no greater than 10%
Price Movements in Last 3 Months: no greater than 15%
Delta Neutral: N/A
PRICE NEGOTIATION:
Trade one side at a time. IE: PUT Spread and CALL Spread should be traded separately.
Determine the lowest price to accept on each Spread before starting to trade.
Start at the Mid Price. Increase price by the smallest amount possible ($0.01, $0.05, etc.), and wait before changing the price again. Never exceed the lowest price limit.
TRADE MONITORING:
Remove the trade if the Delta of the Short Strike reaches 30.
Remove the trade if VIX makes a fresh 6 week high. If 6 week high printed today, if in trade, get out today if a Friday, otherwise exit the next day only if close prints as a fresh 6 week high.
Never let the market price reach the short Strike, as the cost to exit will be significant.
When the cost to remove the position is $0.15 or less, remove it.
CONDITIONAL ORDERS EXAMPLE:
Assume that the current price of AcmePlus stock is $100 per share. For the Call Condor, we sold 1 Contract | ACMEPLUS | JUNE | 110 | CALL | Delta = .07. We bought 1 Contract | ACMEPLUS | JUNE | 115 | CALL. When considering conditional orders, the est. delta of short @ 105 was 16, and est. delta of @ 108 was 30. For the Put Condor, we sold 1 Contract | ACMEPLUS | JUNE | 90 | PUT | $1.10 per share | Delta = .08. We bought 1 Contract | ACMEPLUS | JUNE | 85 | PUT | $0.45 per share. For the conditional orders, @ 95 the est. delta of short was 16, and @ 92 was 30.
NOTE: We create 2 independent conditional orders; one for the CALL Condor, and a separate conditional order for the PUT Condor. We do not need to remove both sides of the Iron Condor at the same time. We can simply remove the side that is problematic.
CONDITIONAL ORDER for the CALL Condor:
STEP A) Select "Single Order"
STEP B) Select the CALL Condor Trade, and create a 'closing order'. (You can manually select the opposite spread to close the position if your Broker doesn't have the 'closing order' possibility.). Time in Force: GTC (Good 'Til Cancelled). Price Rules: Market (We don't want to set a limit price, because we don't know what the pricing will be and we want to close this position if the underlying hits our break-even point.). Submit at Specified Market Condition: When the "MARK" of the Underlying is "AT OR ABOVE" price of "108". (The trigger is the price of the Underlying when the Delta of our Short position reaches our exit level, in this case a Delta of 30.)
Your broker will describe this trade as:
1. Wait until the following condition is satisfied: mark price of the security is more or equal to 108.00. This order will show a WAIT COND status during waiting;
2. Submit the following order: BUY +1 VERTICAL ACMEPLUS JUNE 110/115 CALL at current market price. The order is valid until it is either filled or cancelled;
STEP C) Confirm that the trade was entered correctly, and submit the trade. We now have a conditional order that will close our CALL Condor if the underlying price hits $108. (Our PUT Condor will NOT be affected, nor will any conditional orders that we placed on the PUT Condor.)
NOTE: If we decide to manually exit positions, we must first cancel ALL conditional orders that we placed on those positions.
CONDITIONAL ORDER for the PUT Condor:
STEP A) Select "Single Order"
STEP B) Select the PUT Condor Trade, and create a 'closing order'. Time in Force: GTC (Good 'Til Cancelled). Price Rules: Market. Submit at Specified Market Condition: When the "MARK" of the Underlying is "AT OR BELOW" price of "92". (The trigger is the price of the Underlying when the Delta of our Short position reaches our exit level, in this case a Delta of 30.).
Your broker will describe this trade as:
1. Wait until the following condition is satisfied: mark price of the security is less or equal to 92.00. This order will show a WAIT COND status during waiting;
2. Submit the following order: BUY +1 VERTICAL ACMEPLUS JUNE 90/85 PUT at current market price. The order is valid until it is either filled or cancelled;
STEP C) Confirm that the trade was entered correctly, and submit the trade. We now have a conditional order that will close our PUT Condor if the underlying price hits $92. (Our CALL Condor will NOT be affected, nor will any conditional orders that we placed on the CALL Condor.)
NOTE: As always, if we decide to manually exit positions, we must first cancel ALL conditional orders that we placed on those positions.
Breakout Strategy
Our Breakout Strategy is directional in nature, and is triggered by a change in the direction of, and momentum of the VIX index, for the purposes of trading in the S&P 500/ SPX.
BEARISH TRADE RULES:
1. On VIX, last close was up, TRIX^ has made a fresh cross upwards, and SAR* is supportive
2. On Index, both TRIX^ and SAR* are supportive
Buy ATM Puts via a limit order at midpoint.
Exit 1/2 of trade @ 50% profit, and remainder at 100% profit.
Risk 10% of account.
OPTION STRATEGY - LONG PUT
This strategy consists of buying puts as a means to profit if the index price moves lower. It is a candidate for bearish investors who want to participate in an anticipated downturn. The time horizon is limited to the life of the option, but in our case would be no more than 2 weeks. The investor is looking for sharp decline in the index price during life of option.
EXAMPLE: Long 1 XYZ 60 put
MAXIMUM GAIN: Strike price - premium paid
MAXIMUM LOSS: Premium paid
BULLISH TRADE RULES:
1. On VIX, last close was down, TRIX^ has made a fresh cross downwards, and SAR* is supportive
2. On Index, both TRIX^ and SAR* are supportive
Buy ATM 2nd month Calls (30 - 59 days to expiry) via a limit order at midpoint.
Exit 1/2 of trade @ 25% profit, and remainder at 50% profit.
Risk 10% of account.
OPTION STRATEGY - LONG CALL
This strategy consists of buying calls as a means to profit if the index price moves higher. It is a candidate for bullish investors who want to participate in an anticipated upturn. The time horizon is limited to the life of the option, but in our case would be no more than 2 weeks. The investor is looking for sharp decline in the index price during life of option.
EXAMPLE: Long 1 XYZ 60 put
MAXIMUM GAIN: Strike price - premium paid
MAXIMUM LOSS: Premium paid
^ Daily bars, period of 12 & signal of 9
* Daily bars, step of 20, acceleration of 2
A Short Iron Butterfly (we will call it a Butterfly) works by selling 2 contracts on the strike near the current market price with the current expiration date, and then buying 1 contract on either side, approximately 1 standard deviation away with the same expiration date. The 'wings', the positions we buy, must be the same distance away from the short strike, otherwise it will create an uneven Butterfly with a maintenance requirement. We can do Butterfly trades on puts and calls, and we generally only stay in the trade for 17 to 20 days. A Butterfly Spread is a debit spread - we pay to enter the trade and there is no maintenance requirement. The value of our long positions will always cover any potential loss from the short positions. Therefore, the maximum amount of loss possible on a Butterfly trade is the amount we pay for the trade.
Let's take our fictitious company AcmePlus as an example. AcmePlus stock is currently trading at $100 per share. We can buy 1 contract of the JUNE 95 call for $5.50 per share, and we sell 2 contracts of the June 100 call for $2.25 per share, and we can buy 1 contract of the June 105 call for $0.40 per share. [Remember that options contracts represent 100 shares of stock.]
When we buy 1 contract of the June 95 call strike for $5.50, we will have to pay $550 immediately to cover that purchase. (We bought 1 contract of the June 95 call for $5.50 per share, and there are 100 shares in 1 contract = $550.). When we sell 2 contracts of the June 100 call strike for $2.25, we will get paid $450 immediately into our brokerage account. (We sold 2 contracts of the June 100 call for $2.25 per share [$225 * 2 = $450]). When we buy 1 contract of the June 105 call strike for $0.40, we will have to pay $40 immediately to cover that purchase. (We bought 1 contract of the June 105 call for $0.40 per share, and there are 100 shares in 1 contract = $40.)
Our gross cost = $140 ($550 + -450 + 40). The maximum possible loss is $140. This is what would happen if the market price of AcmePlus was above or below the max loss point at the June expiration: the expiration of our short strike.
The maximum profit on a Butterfly Spread is at our short strike - in our example it is the 100 strike. In many Butterfly Spreads, the maximum profit at expiration can be over 250%, but don't get too excited just yet. We generally only hold Butterfly trades for 17 to 20 days, and then we exit. If all goes well, we can expect to exit with a nice profit of 10% to 20%. It is possible to hold a Butterfly spread on a cash settled index until expiration.
SPREAD TRADES:
When we trade options, we don't have to go through the process of buying and selling the individual options of our Butterfly or other spread trades. We can make a "spread" order, where we specify what options we want to buy and sell, and we can say what NET amount we want to get. On a Butterfly, we can generally get better pricing by splitting the trade up into 2 Vertical Spreads:
# 1: Vertical Spread with: 1 Long and 1 Short.
# 2: Vertical Spread with: 1 Short and 1 Long.
COST & MARGIN REQUIREMENTS:
Debit Spread. We pay to enter the trade.
Maintenance Requirement: There is no maintenance. Our maximum loss is the amount we paid for the Butterfly spread.
HOW WE PROFIT:
We profit on a Butterfly trade through the reduction of time premium of our short positions during the 17 to 20 days that we are in the position. Since one of our long positions is in the money, almost all of the cost of that option will be intrinsic value. However, the amount that the position is in the money, the value of our short positions, will be almost all time value. As we get closer to expiration, we will be able to sell our long positions for about what we paid for them. However, it will cost us less to buy back our short positions, and we end up with a profit. In essence, we buy the Butterfly at a low price, and then sell to close it later at a higher price.
HOW WE CAN HAVE A LOSS:
When the underlying has unusual price movements in one direction that force us to remove our positions early.
When the Implied Volatility (IV) goes up / trends up.
PROBABILITIES:
Butterfly Trades have probabilities of success around 50%. It is possible to combine multiple Butterfly positions to widen the area of profitability. It is also possible to remove and replace Butterfly's according to Market movements.
BUTTERFLY EXAMPLE:
The current price of AcmePlus stock is $100 per share.
Example of a Call Butterfly:
We buy 1 contract | ACMEPLUS | June | 95 | Call | $5.50 per share
We sell 2 contracts | ACMEPLUS | June | 100 | Call | $2.25 per share (-225 * 2 = -450)
We buy 1 contract | ACMEPLUS | June | 105 | Call | $0.40 per share
Gross debit = $140 ($550 + -450 + 40)
Maintenance = zero (There is no maintenance on Butterflys; the maximum loss is what you paid for the trade.)
BUTTERFLY TRADE RULES:
Butterfly Trades place the Short Strikes near the current price of the underlying, and the Long Strikes are equally distant at approximately 1 Standard Deviation for 17 Days away from the short strikes. It is held for 17 to 20 days. We can do Butterfly trades on puts and calls.
TIME FACTORS:
Time to enter trade: 35 days until 25 days prior to expiration
Preferred time to enter trade: 30 days prior to expiration
Minimum Time Premium: N/A
Earnings and News: on Stocks: no news, no earnings, no mergers, no splits, no takeovers, etc. Any one of those items can cause the price of the underlying to jump.
Time in trade: 17 to 20 days. Butterflys can be held until expiration.
VOLATILITY FACTORS:
Maximum IV: less than 35
IV Range: any IV value is okay. High IV is okay if you think it will go down
IV Channeling: channeling for at least 45 days
IV Trend Up = fair to bad
IV Trend Down = good
IV Skew Range: n/a
PRICE FACTORS:
Minimum Underlying Price: $75 - if the price of the underlying is too low, the price of the options will be too low, and there won't be enough time premium decay to create a healthy profit.
Strike Pricing: long positions approximately 1 standard deviation based on 17 days expiration. Evaluate the price of Puts vs Calls and choose whichever has the best pricing.
Minimum Premium: N/A
Price Movements in Last Week: <5%
Price Movements in Last Month: <10%
Price Movements in Last 3 Months: <15%
Delta Neutral: for advanced traders, it is recommended to be delta neutral when placing the trade. Add extra Long positions to balance the delta, but be careful not to reduce the theta by more than half.
BUTTERFLY PRICE NEGOTIATION:
It is best to trade one spread at a time
Determine the highest price to pay before starting to trade.
Start at the Mid Price and wait - increase price by the smallest amount possible ($0.01, $0.05, etc.), and wait before changing the price again. Never exceed the highest price limit.
TRADE MONITORING:
If the underlying reaches the expiration break-even point, exit the trade.
If the IV trend goes up, exit the trade.
If the price movement of the underlying exceeds the trade initiation values, exit the trade.
If the time in trade exceeds 20 days, the position should be monitored very closely or exit.
Butterfly trades on cash settled indexes can be held until expiration.
SUGGESTED CONDITIONAL ORDERS:
The current price of AcmePlus stock is $100 per share.
CALL Butterfly
We buy 1 contract | ACMEPLUS | June | 95 | Call
We sell 2 contracts | ACMEPLUS | June | 100 | Call
We buy 1 contract | ACMEPLUS | June | 105 | Call
Break-even up-side: 103
Break-even down-side: 97
STEP A) Select "Single Order"
STEP B) Select the Butterfly Trade, and create a 'closing order'. (You can manually select the opposite spread to close the position if your Broker doesn't have the 'closing order' possibility.). Time in Force: GTC (Good 'Til Cancelled). Price Rules: Market (We don't want to set a limit price, because we don't know what the pricing will be and we want to close this position if the underlying hits our break-even point.). Submit at Specified Market Condition #1: When the "MARK" of the Underlying is "AT OR ABOVE" price of "103" (Make sure to use the Up-side break-even). Submit at Specified Market Condition #2: When the "MARK" of the Underlying is "AT OR BELOW" price of "97" (Make sure to use the Down-side break-even)
Your broker will describe this trade as:
1. Wait until at least the one of the following conditions is satisfied (this order will show a WAIT COND status during waiting):
mark price of the security is less or equal to 97.00;
mark price of the security is greater or equal to 103.00;
2. Submit the following order: SELL -1 BUTTERFLY ACMEPLUS JUNE 95/100/105 CALL at current market price. The order is valid until it is either filled or cancelled.
STEP C) Confirm that the trade was entered correctly, and submit the trade.
We now have a conditional order that will close our Butterfly trade if the underlying price hits ONE of our break-even points.
NOTE: If we decide to manually exit positions, we must first cancel ALL conditional orders that we placed on those positions.
Double Diagonal's are attractive when you believe implied volatility is low, and will be higher in the near future. Otherwise, it’s less risky to trade the iron condor. A Double Diagonal is a hybrid combination of an Iron Condor and a Calendar, and works by Selling an Option on the Strike approximately 1 Standard Deviation away from the current price with the current Expiration Date, and then buying the Next Strike Out on the Next Expiration Date. Think of it like a Condor, except that the Long Position is in the Next Expiration Date. Same underlying, different Strike, different Expiration dates. A Diagonal is one side, either the CALL or the PUT. We normally trade both the CALL and PUT together as a Double Diagonal. Putting on a single Diagonal trade is a speculative Directional trading technique, something we don't recommend. A Double Diagonal can be either a DEBIT spread or a CREDIT spread. The price depends on the Volatility and relative pricing of the Options. In practice, trades that start out with close to zero credit or debit can be easier to adjust, but it's not a fixed rule. The decision to enter a Double Diagonal should be judged based on the Expiration graph, not on the initial credit / debit.
The middle of the graph should never 'sag' below the break-even line. The higher the sag is, the better the trade is, on the condition that we didn't pull our Short Positions in too close to do so. The goal is to have our Short positions as far away from the Market price as possible, but still maintain a middle 'sag' that is as high as possible.
Double Diagonals ALWAYS have MAINTENANCE. The profit spread of a Double Diagonal is very wide and high; however, there is a corresponding risk that is also high. The amount of maximum loss on a Double Diagonal is like taking the potential loss on both sides of a Condor. Brokers will hold for maintenance the full potential loss which is approximately the same as if you calculate both sides of the 'Condor' spread from this trade.
Let's take our fictitious company AcmePlus as an example. AcmePlus stock is currently trading at $100 per share. For example, 1 Standard Deviation, according to the June Expiration, is 15 points away. We would put on both a CALL Diagonal and a PUT Diagonal:
CALL Diagonal: We can Sell the 115 CALL Strike for the JUNE Expiration for $2.00 per share, and we can Buy the 120 CALL Strike for the JULY Expiration for $2.10 per share. [Remember that Options Contracts represent 100 shares of stock.]
When we Sell 1 CONTRACT of the JUNE 115 CALL Strike for $2.00, we will get paid $200 immediately into our Brokerage account. (We sold the JUNE 115 CALL for $2.00 PER SHARE, and there are 100 shares in 1 CONTRACT = $200.)
When we Buy 1 CONTRACT of the JULY 120 CALL Strike for $2.10, we will have to pay $210 immediately to cover that purchase. (We bought the JULY 120 CALL for $2.10 PER SHARE, and there are 100 shares in 1 CONTRACT = $210.)
Our Gross Cost = $10. (We received $200 for the sale of the 1 CONTRACT JUNE 115 CALL Strike, and we paid $210 for the 1 CONTRACT JULY 120 CALL Strike: $200 - $210 = -$10.)
The possible gross loss is $500. This is based on the Vertical risk between our Short position at the 115 Strike, and our Long position at the 120 Strike: similar to a Condor.
PUT Diagonal: We can Sell the 85 PUT Strike for the JUNE Expiration for $2.20 per share, and we can Buy the 80 PUT Strike for the JULY Expiration for $2.35 per share.
When we Sell 1 CONTRACT of the JUNE 85 PUT Strike for $2.20, we will get paid $220 immediately into our Brokerage account.
When we Buy 1 CONTRACT of the JULY 80 PUT Strike for $2.35, we will have to pay $235 immediately to cover that purchase.
Our Gross Cost = $15. The possible gross loss is $500. This is based on the Vertical risk between our Short position at the 85 Strike, and our Long position at the 80 Strike: similar to a Condor.
The maximum possible loss could be slightly higher than $1,000 because of the offsetting month. However, for the sake of calculation we can add up the possible gross loss at each side to calculate the Maximum Loss / Maintenance amount on this trade to be $1,000 total ($500 CALL side + $500 PUT side).
The maximum profit on a Double Diagonal Spread is at our Short Strikes, and the maximum profit at expiration can be well over 50%. Aside from the high profit amounts at Short Strike positions, the Double Diagonal has a very wide area of profit.
We generally only hold Double Diagonal trades for 20 to 25 days, and then we exit. If all goes well, we can expect to exit with a nice profit of 10% to 15%.
We don't ever hold a Double Diagonal spread until Expiration because the settlement value and the Market price of our Long position can be grossly out of sync and we could end up with a large loss, plus we might have to do a lot of fast juggling in our Brokerage account dealing with a Short position that Expires In The Money.
SPREAD TRADES:
When we trade Options, we don't have to go through the process of buying and selling the individual Options of our Double Diagonal or other spread trades. We can make a "Spread" order, where we specify what Options we want to Buy and Sell, and we can say what NET amount we want to get. (See the explanation in the Condor and Calendar sections.)
We will generally get better pricing by trading the PUT Diagonal and the CALL Diagonal separately.
COST & MARGIN REQUIREMENTS:
Debit or Credit Spread. It is price dependent, we may pay to enter the trade like a Debit spread, or we can get paid like a Credit spread. If all else is equal, a general guide is to try to enter trades with a minimal cost or debit.
Maintenance Requirement: There is Maintenance. The maintenance amount can be roughly calculated by treating each side like a Condor, and ADDING the max loss from both sides together.
HOW WE PROFIT:
We profit on a Double Diagonal trade through the reduction of Time Premium during the 20 - 25 days that we are in the position. The Time Premium of our Short position, which is getting close to Expiration, will drop much faster than the Time Premium of our Long position, which has a more distant Expiration. Our profit will increase at the Short Strikes because the value of our Long Positions as compared to our Short positions will be highest.
HOW WE CAN HAVE A LOSS:
When the underlying has unusual price movements in one direction that force us to remove our positions early.
When the Implied Volatility (IV) goes down / trends down, then the price of our Options drops, thus eliminating any Time Value decay that we were counting on for a profit.
When an IV Skew greater than 4 or 5 develops, which will adversely affect our Options pricing.
PROBABILITIES:
Calendar Trades have probabilities of success generally over 60%.
DOUBLE DIAGONAL EXAMPLE:
The current price of AcmePlus stock is $100 per share.
CALL Diagonal:
We SELL 1 Contract | ACMEPLUS | JUNE | 115 | CALL | $2.00 per share
We BUY 1 Contract | ACMEPLUS | JULY | 120 | CALL | $2.10 per share
GROSS DEBIT = $10 ($0.10 per share)
MAINTENANCE = $500 (Calculated like the possible loss on a Condor, the Vertical difference between our Short: 115 and Long: 120 strikes.)
PUT Diagonal:
We SELL 1 Contract | ACMEPLUS | JUNE | 85 | PUT | $2.20 per share
We BUY 1 Contract | ACMEPLUS | JULY | 80 | PUT | $2.35 per share
GROSS DEBIT = $15 ($0.15 per share)
MAINTENANCE = $500 (Calculated like the possible loss on a Condor, the Vertical difference between our Short: 85 and Long: 80 strikes.)
Double Diagonal Total:
DEBIT = $25
MAINTENANCE = $1,000
DOUBLE DIAGONAL TRADE RULES:
On a Double Diagonal Trade, the SHORT STRIKES are generally placed approximately 1 Standard Deviation away from the Current price based on the Expiration date. We will trade both the PUTs and CALLs; we treat the Double Diagonal as one large spread. If you only trade one side, that would be a Directional Option trade where you are trying to guess the direction of the market, which is what we avoid.
Make sure that the 'sag' in the middle of the "Yield at Expiration" graph does NOT go below the break-even line.
Double Diagonal’s are generally held for 20 to 25 days.
TIME FACTORS:
Time to Enter Trade: 45 days until 30 days prior to expiration
Preferred Time to Enter Trade: 40 days prior to expiration
Minimum Time Premium: N/A
Earnings and News: On Stocks: no news, no Earnings, no mergers, no splits, no takeovers, etc. Any one of those items can cause the price of the Underlying to jump.
Time In Trade: 20 to 25 days.
VOLATILITY FACTORS:
Maximum IV: Less than 32.
IV Range: Lower 1/3 of the IV range for the last 2 years. Lowest is best.
IV Channeling: Channeling for at least 45 days.
IV Trend UP: Good.
IV Trend DOWN: Bad.
IV Skew Range: Between -2 to +5.
PRICE FACTORS:
Minimum Underlying Price: $70. If the price of the underlying is too low, the price of the Options will be too low, and there won't be enough Time Premium decay to create a healthy profit.
Strike Pricing: Short Strike 1 Standard Deviation away from underlying price. If the IV is "low" we can move in slightly. If the IV is "high" we can move the Short Strikes out more.
Minimum Premium: The price of the Short Strike cannot be less than $1.00. The price of the Long cannot be more than 1.5 times the price of the Short.
Price Movements in Last Week: +/- 5%
Price Movements in Last Month: +/- 10%
Price Movements in Last 3 Months: +/- 15%
Delta Neutral: N/A
GRAPH FACTOR:
The 'sag' in the middle of the "Yield at Expiration" graph should NOT be below the break-even line.
PRICE NEGOTIATION:
It is best to trade one Spread at a time: Trade the CALL and PUT Spreads separately. Determine the highest price to pay or lowest Credit to accept on each Spread before starting to trade. It is best to shoot for Double Diagonals that are as close to zero as possible: a small Debit or Credit is fine. Trades with a large Debit or Credit should be used only for Advanced Double Diagonal Traders. Start at the Mid Price and wait a few minutes. (Be more patient if you have one large order with all 4 legs.). Increase price by the smallest amount possible ($0.01, $0.05, etc.), and wait before changing the price again. Never exceed the highest price limit.
TRADE MONITOR RULES:
If the underlying reaches the Expiration break-even point, exit the trade.
If the IV Skew goes above 5, exit the trade.
If the IV Trend goes down, exit the trade.
If the price movement of the underlying exceeds the Trade Finder values, exit the trade.
If the Time in Trade exceeds 25 days, the position should be monitored very closely or exit.
If the Time remaining until Expiration is 3 days or less, exit the trade. Do not let a Double Diagonal trade go until Expiration.
DOUBLE DIAGONAL CONDITIONAL ORDERS:
EXAMPLE: The current price of AcmePlus stock is $100 per share.
CALL Diagonal:
We SOLD 1 Contract | ACMEPLUS | JUNE | 115 | CALL
We BOUGHT 1 Contract | ACMEPLUS | JULY | 120 | CALL
break-even up-side: 118
PUT Diagonal:
We SOLD 1 Contract | ACMEPLUS | JUNE | 85 | PUT
We BOUGHT 1 Contract | ACMEPLUS | JULY | 80 | PUT
break-even down-side: 82
NOTE: Technically we do Not need to remove both sides of the Double Diagonal at the same time. We can simply remove the side that is problematic, and leave the other side 'live'. However, it is likely that if one side of the Double Diagonal is in trouble, the other side will also be problematic. We calculate the break-even points by treating both sides together as one big trade, so when a break-even point is reached, we remove both sides of the trade. We do this by having 2 conditional orders, and as soon as one order is filled, it will make the other order live so that we will completely close this trade. It is possible to make one large 4 leg order that will remove all of the positions, but you need to set both the up-side and down-side trigger points. Look at the Butterfly Conditional Order example to see how we set 2 trigger points on one order.
This example is for 2 separate orders, where one order triggers the other:
STEP A) Select "Advanced Trade": 1st Triggers ALL (One Triggers ALL other orders in this group.) This is critical, because when one of the trades is filled, we want the other order to go live so it will completely close our Double Diagonal position.
STEP B) Down-side break-even:
Select the PUT Diagonal Trade, and create a 'closing order'. (You can manually select the opposite spread to close the position if your Broker doesn't have the 'closing order' possibility.)
Time in Force: GTC (Good 'Til Cancelled)
Price Rules: Market (We don't want to set a limit price, because we don't know what the pricing will be and we want to close this position if the underlying hits our break-even point.)
Submit at Specified Market Condition: When the "MARK" of the Underlying is "AT OR BELOW" price of $82.00. Make sure to use the Down-side break-even.
Your broker will describe this trade as:
1. Wait until the following condition is satisfied: mark price of the security is less or equal to $82.00. This order will show a WAIT COND status during waiting;
2. SELL -1 DIAGONAL ACMEPLUS JULY/JUNE 80/85 PUT at current market price. The order is valid until it is either filled or cancelled;
STEP C) Up-side break-even:
Select the CALL Diagonal Trade, and create a 'closing order'.
Time in Force: GTC (Good 'Til Cancelled)
Price Rules: Market
Submit at Specified Market Condition: When the "MARK" of the Underlying is "AT OR ABOVE" price of $118.00. Make sure to use the Up-side break-even.
Your broker will describe this trade as:
1. Wait until the following condition is satisfied: mark price of the security is less or equal to $118.00. This order will show a WAIT COND status during waiting;
2. SELL -1 DIAGONAL ACMEPLUS JULY/JUNE 115/120 CALL at current market price. The order is valid until it is either filled or cancelled;
STEP D) Confirm that the trade was entered correctly, and submit the trade.
We now have a conditional order that will close our Double Diagonal trade if the underlying price hits ONE of our break-even points.
NOTE: If we decide to manually exit positions, we must first cancel ALL conditional orders that we placed on those positions.
A Long Calendar Spread (we will call it a Calendar) works by selling an option on the strike close to the current market price with the current expiration date, and then buying the SAME STRIKE on the next expiration date. Same underlying, same strike, different expiration dates. We can do Calendar trades on PUTs and CALLs.
A Calendar Spread is a DEBIT spread: we pay to enter the trade and there is no maintenance requirement. The value of our long position, the one with the further expiration date, will always have more time value than our short position which is the closer expiration date. Therefore, the maximum amount of loss possible on a Calendar trade is the amount we pay for the trade.
Let's take our fictitious company AcmePlus as an example. AcmePlus stock is currently trading at $100 per share. We can sell the 100 call strike for the June expiration for $3.00 per share, and we can buy the 100 call strike for the July expiration for $7.00 per share. [Remember that options contracts represent 100 shares of stock.]. When we sell 1 contract of the June 100 call strike for $3.00, we will get paid $300 immediately into our brokerage account. (We sold the June 100 call for $3.00 per share, and there are 100 shares in 1 contract = $300.). When we buy 1 contract of the July 100 call strike for $7.00, we will have to pay $700 immediately to cover that purchase. (We bought the July 100 call for $7.00 per share, and there are 100 shares in 1 contract = $700.). Our gross cost = $400. (We received $300 for the sale of the 1 contract June 100 call strike, and we paid $700 for the 1 contract July 100 call strike: $300 - $700 = -$400.). The maximum possible loss is $400. This is what would happen if the market price of AcmePlus was above or below the max loss point at the June expiration: the expiration of our short strike.
The maximum profit on a Calendar Spread is at our short strike, which in our example is the 100 Strike. In many Calendar Spreads, the maximum profit at expiration can be over 100%, but don't get excited just yet. We generally only hold Calendar trades for 14 to 21 days, and then we exit. If all goes well, we can expect to exit with a nice profit of 10% to 20%. We don't ever hold a Calendar spread until expiration because the settlement value and the market price of our long position can be grossly out of sync and we could end up with a large loss, plus we might have to do a lot of fast juggling in our brokerage account dealing with a short position that expires in the money.
SPREAD TRADES:
When we trade options, we don't have to go through the process of buying and selling the individual options of our Calendar or other spread trades. We can make a "spread" order, where we specify what options we want to buy and sell, and we can say what NET amount we want to get. In our example above, we can put in a LIMIT spread order to sell 1 contract of the June 100 call strike and buy 1 contract of the July 100 call strike, and we want a net debit of not more than $4.00 per share. We then leave the pricing of the individual strikes of our position up to the market makers, as long as they give us a net debit of not more than $4.00 per share. Using a Spread Order also protects us against any unfavorable changes in the underlying market price. We don't have to be in a rush to try to fill part of our order with a spread order. With spread orders, we either get the pricing we want or we can walk away.
COST & MARGIN REQUIREMENTS:
=> Debit Spread - we pay to enter the trade.
=> Maintenance Requirement - there is no maintenance. Our maximum loss is the amount we paid for the Calendar spread.
HOW WE PROFIT:
We profit on a Calendar trade through the reduction of time premium during the 14 - 21 days that we are in the position. The time premium of our short position, which is getting close to expiration, will drop much faster than the time premium of our long position, which has a more distant expiration. If it cost us $400 to enter the Calendar trade, we might be able to sell our positions for $450 after 14 days, leaving us with a $50 profit, or 12.5% profit for just 2 - 3 weeks.
HOW WE CAN HAVE A LOSS:
=> When the underlying has unusual price movements in one direction that force us to remove our positions early.
=> When the Implied Volatility (IV) goes down / trends down, then the price of our options drops, thus eliminating any time value decay that we were counting on for a profit.
=> When an IV Skew greater than 4 or 5 develops, which will adversely affect our options pricing.
PROBABILITIES:
Calendar Trades have probabilities of success generally over 50%. It is possible to combine multiple Calendar positions to widen the area of profitability. It is also possible to remove and replace Calendars according to Market movements.
CALENDAR EXAMPLE:
The current price of AcmePlus stock is $100 per share.
Example: CALL Calendar
We sell 1 contract | ACMEPLUS | June | 100 | Call | $3.00 per share
We buy 1 contract | ACMEPLUS | July | 100 | Call | $7.00 per share
Gross Debit = $400 ($4.00 per share)
Maintenance = zero (there is no maintenance on Calendars, the maximum loss is what you paid for the trade.)
CALENDAR TRADE RULES:
Calendar Trades are generally placed at the Strike near the current price of the underlying, and held for 14 to 21 days. We can do Calendar trades on puts & calls.
TIME FACTORS:
Time to Enter Trade: 35 days until 25 days prior to expiration
Preferred time to enter trade: 30 days prior to expiration
Minimum time premium: the time premium of a short option should be more than 50% of the time premium of the long option. We are counting on the time premium decay of the short position to make a profit, so there needs to be enough time premium to decay to create a profit.
Earnings and News: on stocks: no news, no earnings, no mergers, no splits, no takeovers, etc. Any one of those items can cause the price of the underlying to jump.
Time In Trade: 14 to 21 days.
VOLATILITY FACTORS:
Maximum IV: Less than 30.
IV Range: Lower 1/3 of the IV range for the last 2 years - lowest is best.
IV Channeling: channeling for at least 45 days.
IV Trend Up = good.
IV Trend Down = bad.
IV Skew Range: between -2 to +5.
PRICE FACTORS:
Minimum Underlying Price: $70. If the price of the underlying is too low, the price of the options will be too low, and there won't be enough time premium decay to create a healthy profit.
Strike Pricing: N/A
Minimum Premium: n/a (minimum premium is covered by the other rules on Calendar trades)
Price Movements in Last Week: <5%
Price Movements in Last Month: <10%
Price Movements in Last 3 Months: <15%
Delta Neutral: n/a
PRICE NEGOTIATION:
If trading multiple Calendars, trade one Spread at a time.
Determine the highest price to pay on each Spread before starting to trade.
Start at the mid price and wait - increase price by the smallest amount possible ($0.01, $0.05, etc.), and wait before changing the price again. Never exceed the highest price limit.
TRADE MONITORING:
If the underlying reaches the expiration break-even point, exit the trade.
If the IV Skew goes below -2, or if it goes above 5, exit the trade.
If the IV Trend goes down, exit the trade.
If the price movement of the underlying exceeds the trade initiation values, exit the trade.
If the Time in Trade exceeds 21 days, the position should be monitored very closely or exit.
If the Time remaining until expiration is 3 days or less, exit the trade. Do not let a Calendar trade go until expiration.
SUGGESTED CONDITIONAL ORDERS:
It is possible to set one conditional order that has two separate trigger points, instead of 2 separate orders. Please see the Butterfly Conditional Order for an example of two trigger points.
Example for a Conditional order to close a Calendar trade - we have a Calendar on Acme:
Current price of Acme (underlying) is 100
Sold 1 | ACME | June | 100 | Call
Bought 1 | ACME | July | 100 | Call
Break-even down-side: 90
Break-even up-side: 110
STEP A) Select "Advanced Trade": OCO (One Cancels the Other). This is critical, because if one of the trades is filled, we don't want the other trade to stay live: it could create a new 'reverse Calendar' position, which we do not want. As soon as one of our conditional orders is filled, the OCO setting will automatically cancel the other conditional order.
STEP B) Down-side break-even:
Select the Calendar Trade, and create a 'closing order'. (You can manually select the opposite spread to close the position if your broker doesn't have the 'closing order' possibility.). Time in Force: GTC (Good 'Til Cancelled). Price Rules: Market (We don't want to set a limit price, because we don't know what the pricing will be and we want to close this position if the underlying hits our break-even point.). Submit at Specified Market Condition: When the "MARK" of the Underlying is "AT OR BELOW" price of $90.00. (Make sure to use the down-side break-even). Your broker will describe this trade as:
1. Wait until the following condition is satisfied: mark price of the security is less or equal to $90.00. This order will show a WAIT COND status during waiting;
2. Submit the following order: SELL -1 CALENDAR ACME JUN/JUL 100 CALL at current market price. The order is valid until it is either filled or cancelled;
STEP C) Up-side break-even:
Select the Calendar Trade, and create a 'closing order'.
Time in Force: GTC (Good 'Til Cancelled)
Price Rules: Market
Submit at Specified Market Condition: When the "MARK" of the Underlying is "AT OR ABOVE" price of "110". Your broker will describe this trade as:
1. Wait until the following condition is satisfied: mark price of the security is more or equal to 110.00. This order will show a WAIT COND status during waiting;
2. Submit the following order: SELL -1 CALENDAR ACME JUN/JUL 100 CALL at current market price. The order is valid until it is either filled or cancelled;
STEP D) Confirm that the trade was entered correctly, and submit the trade.
We now have a conditional order that will close our Calendar trade if the underlying price hits our break-even point, and when the closing trade is filled, it will automatically cancel the other conditional order.
NOTE: If we decide to manually exit positions, we must first cancel ALL conditional orders that we placed on those positions.
Always remember that trading derivatives on margin carries a HIGH LEVEL OF RISK, and may not be suitable for all investors. Before deciding to trade derivatives you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with derivatives trading, and seek advice from an independent financial advisor if you have any doubts.
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