Track That Trade 110418. AAPL Double Diagonal Spread

The Trade

A Jun/May double diagonal spread, using AAPL as the underlying asset, is today’s trade.

Definition: A diagonal spread refers to a position with one long and one short option, with the stipulation that the options have different strikes and different expiration dates.

If a call and put diagonal spread are held simultaneously (same stock), then the position is a double diagonal (DD)

Typically, traders who use this strategy consider it to be in the class of ‘income’ strategies.

  • The longer-dated option
  • The option that is father out of the money
  • Most of the time, the less expensive option
    • This last condition is not required
    • The decision is part of the trader’s style or comfort zone

Reminder: This trade is intended for instructional purposes. I do not, and will not, own this or a similar position for my personal account.


Forced to open this position by trading each leg separately (problem with spread software), the fills were not very good. We paid 4 cents debit for the call spread and traded the put spread at even money.

Below is the trade screen, just after the trades were made:

It’s not clear where we could be filled, but for our records, lets assume the following:

    Call spread: paid 2 cents debit: Paid $2.08 and sold @ 2.06
    Put spread: 6 cents credit (midpoint is 10 cents credit): Paid $3.02 and sold @ $3.08

Risk Graph and Greeks

Why this spread

There is almost always a variety of trades than can be chosen, and I’ve discovered that the double diagonal offers the widest selection.

Expiration date

The first choice is just how far apart the expiration dates should be. These days we can use options that are one week apart (2nd Friday and 3rd Friday, when available) or we can use LEAPS options and separate our longs and shorts by wide intervals.

My preference is for options that are one month apart. Why? Because the double diagonal is a positive vega play. That means an environment of rising implied volatility should be good for the position (unless the market is too volatile). Unless the trader want to make a big play on vega, trading options that expire in consecutive months minimized the vega of the entire position.

Position size

The margin requirement for double diagonals tends to be greater than that for iron condor because (at least when I trade them for my account) it feels right to choose strike prices that are farther apart (more on this below).

In this trade, the strikes are 15 points apart, making the margin requirement $1,500 per double diagonal. An 8-lot consumes $12,000 or 12% of our available margin. That’s more than enough size.

Strike prices

There is so much to say that it’s almost best to say nothing.

When the strikes move farther apart, the potential loss increases. This is a big factor when choosing diagonal spreads, but is often overlooked by traders who place far greater importance on next factor (cash). The major risk factor when trading the diagonal spread is that the underlying asset will make a good-sized move. When that happens, the near-term, closer-to-the-money short option picks up delta quickly, threatening large losses in the immediate future.

These near-term options also come equipped with negative gamma that increases just when the position is losing money and the near-term option becomes uncomfortable to hold.

For those reasons, there is less risk of losing a big sum when the long option has a strike price that is near that of the short option. So why not trade options that are as near to each other as possible (referring to the strike prices)? Because of cost.

Position cost

There is a ‘need’ for traders to make certain spreads for a cash credit. It’s foolish, there is no sound logic behind it, but it is part of trading psychology for most.

I would hope that each of you can learn to overcome certain psychological ‘barriers’ and make trades that your brain tells you are better than the alternative. However, this does not occur overnight.

    One example: The need for some traders to roll for a cash credit. There is a comfortable feeling to know that you still have a chance to earn every penny that you had hoped to earn when opening the trade. Despite the fact that the trade has gone awry and has lost money, by rolling for a cash credit, there is the hope of coming out with an even larger profit. Risk is ignored. The desirability of holding that new position is ignored, and that cash credit provides false comfort.

It’s the same with diagonal spreads. It just feels good to take in cash now, and take out more cash when exiting the trade. That ‘feel good’ feeling does not mean it is the wisest trade.

I try to find a compromise and buy long options that do not require the payment of a big debit. I also look for longs with a delta that is not too far removed from that of the short.

When it comes to being ‘neutral’ I find that ‘delta neutral’ is not always good enough. I’ve discussed it at length elsewhere, but one can be ‘distance neutral’ or ‘dollar neutral’ as well as delta neutral. That is the reason that so many possibilities exist when choosing the strike prices for a diagonal (or double) spread.

Trade Plan

1. The plan is to exit with a profit by covering the May options at a low price – while the June options still retain significant value

2. The success of the plan depends on two items

  • Earnings will not result in a significant price gap
  • Implied volatility will not get crushed once news is released. This play is long vega
  • IV for May and June options are fairly similar. However, on a price movement, May gamma represents the danger
  • 3. Whatever the trade plan, the deciding factor on how we proceed is likely to depend on the results of an earnings release. Thus, a trade plan revision may be imminent.

    4) The major decision points for the plan are where do we plan to exit, and how much pain are we willing to take?
    So much of that answer depends on the price of the June options that all I can write at this time is that it pays to be on top of earnings and be ready to take action – after the market opens. I don’t like to take a delta adjustment when the markets are not open. Nor do I want to get involved with a trade frenzy that occurs in a fast market. [As a side issue, this is extra true with a paper-trading account where I am not certain that I will have access to all necessary information].

    5) This may be virtual cash, but I’d love to trade as it if it were real cash and I’ll d what I can, subject to the limitations imposed by the paper-account.

    6) A dull earnings report and the passage f a few days can work wonders for a position such as this. However, AAPL does not tend to issue tame reports.

    7) Any suggestion that this was poor timing for a double diagonal spread would get no objections from me. The good news is that if we do run into trouble, it’s another educational opportunity.

Update 1. April 20, 2011

Apple gapped higher this morning with two significant changes to the DD spread.

First, the position became delta short and the front-month May call (MAY 360) is now only 15 points out of the money. That may be comfortable for most stocks, but AAPL can move with volatility often enough that this is not a safe position

We are short delta per call spread,and that is not nearly enough to cause any immediate concern. However that 350 level beckons and I’ll be taking a close look if we reach that point soon. I find that it’s better to manage risk by looking at the negative, rather than on the bright side of things.

Second, the put spread reached a point where wanted to lock in the cash credit that was available. A continued rally would result in a shrinkage of that cash credit.

Bought AAPL May 290 P @ $0.60

Sold AAPL Jun 275 P @ $1.02

Credit $0.42

The good news is that the earnings news is behind us and that another big event is not expected prior to the May expiration. However, the news may be regarded as spectacular by some, and who knows whether buyers will continue to push this stock higher. Here is one of many articles about the AAPL’s earnings.

After the adjustment:

Note that the passage of time works wonder for this trade. However, the dream of all premium sellers is that time will pass and that the stock will ‘behave.’ That’s an okay lace to be – unless that trader plans to use ‘hope’ as the basis for the future of the portfolio.’

There is a lot of good stuff that can happen here, but we must be alert to upside danger. The ultimate decision for when to hold, reduce, or exit, or adjust remains with each of us. The value in making this a virtual trade and not a real trade is that we can discuss our plans.

As of now, I have no plans other than to be alert to adjust if AAPL rallies and to exit if and when we can collect a nice cash premium from this portion of the DD.

Update 2. Apr 21, 2011

AAPL earnings were announced after the close yesterday and they were far better than expected.
This morning, AAPL was trading @ $357,or $15 higher than yesterday’s close.
This places us in a discomfort zone because our short option is only 3 points OTM

The opening trade was a double diagonal spread (reduced to a single diagonal yesterday), and we are ‘in trouble’ but it’s not bad and the delta situations not a cause for panic. We are short between 12 to 14 delta per spread (the stock price keeps changing,and thus so does delta for the call options).

I have not yet made any trades and am contemplating several choices. Had I considered this to be an emergency, would have made a quick choice – preferring to do something reasonable rather than take the time to search for the one I believe best suits our needs.

The spread we are short is currently trading .81 bid; .95 offer. Thus we can exit by paying about 90 cents. That’s not much of a loss, considering how far the stock has moved – and how quickly.

Not as bad as it appeared

As I have taken my time, the situation is improving. The call spread can now be covered by paying 65 cents. Considering that we collected $0.42 for the put spread (now trading at only $0.20) the loss is minimal.

    The put spread was less important than the calls once the AAPL began rising. But it is important to manage the entire position. That 20 cents we saved by exiting the puts yesterday makes today’s burden less troubling.

It’s tempting to sit tight, saying that this stock is priced just where we want it to be: near 360, but sufficiently lower than we have no immediate worries. If the stock remains near this price ($352), we will soon achieve a very nice reward. The graph below reinforces what we already know: the passage of time is our ally.

However, sitting tight does leave us in jeopardy, should this stock resume it’s upward trend in a meaningful way. I’d love to do nothing, and that is one of the alternatives. However, that feels undisciplined to me. Some protection is needed. The greeks are not far out of line, but we are short 101 delta and precautions should be taken.

AAPL risk graph

Adjustments being considered

1) Exit. Always one of the choices. Before we can evaluate this choice, we must look at alternatives. Below are the trades that I have been considering

2) Move our short May 360 option to a higher strike price

    Buy AAPL May 360/365 call spread. Cost $1.55 with AAPL @ 351.11 @9:25 CT. Gain 8 delta; Gain 2 gamma per spread
    Buy AAPL May 360/370 call spread. Cost $2.55 with AAPL @ 350.87 @9:26. Gain 14 delta and 5 gamma per spread.

The greeks

AAPL greeks

These choices offer more breathing room and make the position closer to delta and gamma neutral. Being short only 6 gamma, this is much less of a consideration. In fact, either of these trades makes the position gamma long, and if we choose the 370 call, we lose almost all theta.

By investing more cash, we add downside risk to the position. The current position has no downside risk. This is not a big price to pay for making the upside much safer, but we must remember that we can exit at a small loss – and that may be preferable to adding downside risk in exchange for upside risk.

In addition, we would be losing much of our positive theta.

Summary: These trades are worth considering, but I prefer finding something more appealing.

2) I’ve considered moving the long option to a higher (Correction: LOWER. Hat Tip to Bill O) strike. That means

    Buying the Jun 370/375 call spread or
    Buying the Jun 365/375 call spread

    The greeks for these options can be seen in the above image.

These trades cost approximately the same as he May call spreads. by that I mean that rolling to a strike 5 points higher in June (370/375 C spread costs about the same as the 5-point spread in May; the May 360/365 C spread. Ditto for the 10-point spread).

The final decision comes down to which position we prefer to hold. For each adjustment considered, we still hold a diagonal call spread in AAPL. Thus, the first decision must be: Do we want to do this? Are we ready to face the risk of a loss if and when AAPL pushes towards 360? We apparently escaped from this position unscathed. Although that can change in a heartbeat.

3) A simpler choice is to buy some calls and thus add some + delta and (not really needed at this point) gamma. We could buy one to three lots of the Jun 370 or 375 call. We could cover 1 or 2 lots of the May 370 call.

Each of those makes the upside somewhat better, but we would still face a loss on a move through 360, if it comes soon.

4) With the price near 351, we may feel relatively safe (for the moment) and decide to do nothing. This may seem to be a poor choice, but it does have one thing going for it: It is not a permanent decision. We can always make an adjustment later today or over the next few trading days. Remember that the market is closed tomorrow, and three days from now things may look better.

Not an easy decision. Doing nothing is the easiest choice. It allows us to make the most profit but it comes with the highest risk. It also sets a bad precedent for making adjustments.

In my opinion, with the stock @ 350.94 at 10:07 CT, I am going to ask for opinions.

What say ye. Any preferences? Please respond below if you have something to share.

Update 3 and EXIT

Paid 20 cents to exit the call spread.
Bought 20 May 360 @ $3.75
Sold 20 Jun 375 @$3.55
Commissions: $8.24

We had decided to exit when appropriate because risk was concentrated to the upside. It’s likely that holding longer would have produced more profits, but – at least for now – we are managing trades for learning opportunities, and there’s not much to learn from this trade. Hence the early exit.

Before commissions, this trade earned $0.24 * 20.
The first two spreads have been fr small gains. Not exciting stuff. But excitement is not the goal.

By request, the next trade will be more aggressive.

24 Responses to “Track That Trade 110418. AAPL Double Diagonal Spread”

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