Diagonal Spread when selling very short-term options

Here is a recent request for a Track That Trade feature. I thought the discussion could be handled in one lengthy post. In doing the write-up I discovered that this topic is far more complicated that I realized.

Suggestion – a short term diagonal/calendar constructed with weekly/front month option in one of the broad-based indices.


Sometimes there are so many variables to consider that it is not easy to decide whether a trade is viable (whether it fits withing the trader’s comfort zone).

My original thought was that I did not like this trade idea. I still have my doubts, but I see many different possibilities and each of us has to decide whether the risk is worth the reward.

If you are not familiar with diagonal or double diagonal spreads, there is background here, here and here.

Choosing the position

1. Underlying broad based index: SPX
The options being sold are expiration week options (Weeklys)

2. Trade date: Friday, one week prior to expiration. This is one variable that can be changed. There is a good argument for waiting until Monday or Tuesday.

3. Spread width is 5-points. The rationale for preferring 5-point spreads is discussed in this video at the 11:20 minute mark (the time is only visible with the full screen video). I believe that the 5-point spread is significantly better when using very short-term options. Note to SPY (QQQ or IWM) traders: Be careful when deciding between 1- and 2-point widths.

4. Let’s examine two scenarios. In one we build the diagonal by buying options with an additional two-weeks of lifetime (expiration Apr 19). In the other, our long options expire 6 weeks later (May 17) than the shorts. NOTE: The available options change every week. For example, if we were to adopt this strategy next week, then the choices will be between options with one or five weeks of extra lifetime. This is important becasue the width of the calendar spread (distance between the expiration dates) plays a significant role in every aspect of the trade).

5. This is a diagonal spread, not an iron condor. However, that does not change the fact that the greatest risk comes with the possibility that the market makes a significant move higher or lower. When our short option moves into the money (or threatens to do so), our position is in trouble (i.e., there is a high probability that we already lost money and that the probability of losing more is high).

6. I elected to sell 15-delta options. This is my ‘usual’ situation for trading very short-term options. Higher delta options are too close to the money and smaller delta spreads do not pay enough premium. Please know that this is to suit my preferences. Please choose a spread that suits your needs, or request that we Track That Trade for a different position.

7. As we consider different trades, position size changes to keep risk (maximum loss) at approximately equal levels.

Trade data collected Friday March30, 2:10 PM CT.


Looking at live data (Monday), we should notice that the delta of our options are smaller. That’s because there is a reduced chance that any option will move far enough to finish ITM. Time to expiration changed from eight days to five over the weekend. The May options are affected far less than April by the passage of three days.

Warning: It is good for profitability to collect three days of theta. However, we risked three days during which an extraordinary, market-moving news event could occur. For that reason, I prefer to sell Weeklys options on Monday. However, that is a personal choice and does not affect our theoretical discussion of this trade.

[NOTE: If this were a real trade in my account, I would have made the trade Friday morning and not Friday afternoon. I believe the market-moving risk occurs overnight, and not during the hours when our markets are open. Thus, I suggest making thus type of trade early in the trading day, and exiting near the close.]

The Trades

The first video is presented below. It contains discussion plus the original trades.
I will be adding real prices (and discussions) once the market opens.

Video ONE: The setup

View Full Screen Video

Monday AM Update


Notice that OTM deltas have decreased. Why? Because each has a reduced probability of finishing ITM (and delta represents that probability).

Friday afternoon data:

March 30, 2012 2PM

Monday morning data:

Apr 2, 2012; 8:35 AM

Video TWO: Positions are now open

View Full Screen Video

Update Apr 2, noon

Decent-sized rally places our short option in some jeopardy. It is less than 5 points OTM. I do not believe it is time to make a risk-reducing adjustment, but am offering one idea for those who may want to take action now. I would consider rolling down the call spread by 5 points. To do that, we buy the SPX Apr 5 ’12 1430/1435/1440 Call butterfly. [See bottom line in the image below.] The current cost to make this trade is roughly 55 cents. I note that someone is bidding $0.25 for two lots. Is that one of our Members?

Butterfly roll?

Monday 2 PM

SPX is up by 14 points, and that doesn’t feel good. Yet before we do anything rash, let’s take a closer look.
First the risk graph:

Risg Grapg for the 15-point diagonal; Mon 2 PM. SPX: 1422

Next, the quote page:

Quotes; Mon 2PM

Some observations:

  • We are short 23 delta and gamma has reached -6. These are of some concern
  • The mid-point value of this spread (#2 on the quote page) is $2.32.
  • Anyone who believes holding this trade is NOT a good idea, can exit with a profit. Neat!
  • Any trader who prefers to roll down by 5 points (#4) can still buy the butterfly at a price that is $0.05 higher than it was earlier.
  • The risk graph (solid, light blue line) shows a loss of $1,000 (from where we were when the image was taken) if SPX rises to 1430. Most traders would probably prefer to exit – especially because it is so painless, but it is not anything I consider to be mandatory. It is conservative – and I do suggest that less than aggressive traders should not hold this trade unadjusted.
  • The MAIN RISK RIGHT NOW is the gap opening tomorrow
  • Other Apr 19/Apr 5 spreads are in more trouble becasue the delta of their long option is less. For these positions I do suggest a butterfly roll, rolling up your long option by one strike, closing a portion of the trade, or exiting.

Tuesday Update

Tuesday. One minute after the market opened

The white arrow points to the delta of our short option. It is only 16 – and that doers not feel too risky. That is false comfort, as that strike remains only 1% out of the money.

None of the individual spreads is in trouble. Yet, not are truly comfortable to hold. Short discussion below.

Video 3

Tuesday update 2PM

The market continues to decline and we are now delta long in everything. Thus, there is now downside risk as well as upside risk. There are two basic choices: Take the money and run. Or hold overnight – hoping that there is no significant gap in either direction. Remember that Friday is a market holiday (Good Friday) and expiration may be nearer than you thought.

Tuesday 2PM. SPX 1407

Wednesday. After the opening

View Full Screen Video

This is the final installment.
Trade closed.

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