Protecting an Iron Condor with a Diagonal Spread

I am a big believer in adopting an overall trading philosophy that makes sense to the trader. However, when tackling the markets, risk management plays an essential role and cannot be ignored.

Today’s question first appeared in the forum (reply #6), but is worthy of a lengthy discussion.

Hi Mark,

I bought a diagonal for upside protection. Even though I paid a debit on the protection, I assumed that even if the underlying moved in the negative direction, the value of the diagonal would never approach zero since the back month option would still have some time value left in it (assuming the negative move is not very huge)

I would assume that if the underlying moves down a bit, the value of the diagonal would decline but this would be reasonable since the call spread it is meant to protect would be losing in value more than the diagonal. However what I noticed was that even though the diagonal (by itself) is delta and theta positive, it loses value when the underlying slowly creeps up (with little change in VIX). This is a disconcerting position to be in since both the short call spread and the protection are losing money.

I find it difficult to pick a calendar when options are in contango and am asking if there is a better way to choose. I am not asking for exact trades but rather some logical way of thinking that I can follow.


Excellent points for discussion.

Here are some basic ideas that I repeat for emphasis:

  • Options are versatile and there are many different ways to use them.
  • Making a trade that seeks to profit as a stand-alone trade is very different from making a trade for protection.
  • A trade made FOR PROTECTION must be profitable (on its own) when the market threatens the protected position.

The diagonal as protection

When the futures and options are in contango is not a good time to initiate a calendar (or diagonal) spread. The exception occurs when you believe that the contango will INCREASE.

Next, the BIG DEBIT diagonal is never a good idea (in my opinion) because the diagonal would lose money on a big move in either direction.

A smallish debit is fine, and a cash credit is even better. However, to generate a credit, we often have to own a position with a large separation between the strike prices (spread width) – and that is not a good idea because it significantly diminishes protection. [The diagonal spread loses money when the short option threatens to move ITM.]
Thus, choosing the specific diagonal can be tricky. But more importantly, when IV is high, or when the option you buy has a higher IV than the one you sell, that is not the right scenario for buying a spread FOR PROTECTION. Why? Because the diagonal is long vega and the idea of owning positive vega spreads is to buy when vega is inexpensive – and there is a reasonable expectation that IV will be increasing during the lifetime of the trade. When in contango, there is no such expectation.

My conclusion is that diagonals are almost a never a satisfactory trade as protection. I concede this: If you want to take the chance that the markets will not be volatile and that you will always have an opportunity to make additional adjustments as needed, then yes, the diagonal can work. However, one of the ideas behind protecting an existing position is that we want to be fairly certain that nothing bad can happen. If the market gaps higher and your diagonal spread moves ITM – that would be a disaster. The short call spread being protected will also be losing big money at that time. That is not protection.

Diagonal spreads are good for adding vega to a portfolio (when you are short too much vega); they are good for playing for a home run (i.e., the diagonal is a big winner when the iron condor is also a big winner), but they are not good for protection against a short call spread.

The calendar as protection

The calendar spread is also a vega positive trade. However, it may be bought as protection in specific situations. My recommendations:

  • The spread is fairly far out of the money at the time it is made, and thus, the spread is not expensive
  • Buying positive vega is appropriate for your portfolio

For example, if a trader is short an SPX 1450 call (as part of a call spread) and wants some upside protection, owning a calendar – in which the short option expires at the same time as the call spread being protected – then buying a calendar struck at 1450, 1460, or 1470 offers some upside protection. However, this trade cannot be made when the 1450 strike is already being threatened. That would be far too late, and far too costly. Buy the calendar when it is cheap – and that means the options are fairly far OTM.

Trader Mindset

I understand the mindset of some traders. The following is not a healthy mindset:

  • I want protection.
  • I do not want to pay time decay to buy options.
  • I do not want to lose money when buying that protection.
  • Why shouldn’t I buy protection that may add to my profit potential?
  • I will not exit this trade. I will not take a loss.

This is a much healthier mindset:

  • I need protection and that is the primary problem to solve.
  • I may have to buy some positive gamma to reduce risk, and that means paying time decay. No problem.
  • I cannot afford to lose money on both the original trade and the adjustment. That limits my adjustment choices. If this adjustment adds to profits – that’s a bonus. However, it is not my primary objective.
  • If I cannot find a satisfactory method for reducing risk, I will exit the trade.

-s: I cannot suggest any reasonable method for choosing a calendar spread as protection. By the time you need the protection, the calendar is already too expensive. I like the idea if FOTM calendars as insurance – and I would consider buying tham t the time that I make the original trade. In other words, before protection is needed.

However, I leave you with this thought: Protecting your assets comes first. If you love calendar or diagonal spreads, then trade them as stand-alone trades. However, when looking to protect a position that is in trouble, it is more important to gain protection and come out of the adjustment trade with a good position than it is to employ your favorite strategy. When contango exists, there is only one way to benefit from the positive vega of the calendar spread – and that is for contango to increase. If you believe that will happen, then the calendar is a viable choice.

Value of the Diagonal

You observed that:

Delta is positive
Theta is positive
VIX is unchanged

Yet, you lose money when the market ‘slowly creeps up,’ and this makes you uncomfortable.

Here is how I see it: VIX is calculated by using a specific set of options. They expire in the front and 2nd months and are not too far OTM. The CBOE publishes details of how the calculation is made. The main point to understand is that the number of different option series used for those calculations is limited, and many options – especially longer term options – are ignored for the purposes of calculating VIX.

You may see VIX remaining essentially unchanged, but what about contango? What I believe is happening is that contango has been decreasing recently. That means it is likely that the implied volatility of your long option has been declining even if that of your short option has not. If theta and delta are on your side and your position is losing money on the rally, vega must be the culprit. The price change of the spread is not important from one day to the next because there can be plenty of aberrations in a single data point. However, if you are seeing this over several days, then the loss is real. And my best explanation is a contango decrease.

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