NOTE: This graph assumes the strategy was established for a net debit. Also, notice the profit and loss lines are not straight. That’s because the back-month put is still open when the front-month put expires. Straight lines and hard angles usually indicate that all options in the strategy have the same expiration date.
You can think of this as a two-step strategy. It’s a cross between a long calendar spread with puts and a short put spread. It starts out as a time decay play. Then once you sell a second put with strike B (after front-month expiration), you have legged into a short put spread. Ideally, you will be able to establish this strategy for a net credit or for a small net debit.
For this Playbook, I’m using the example of one-month diagonal spreads. But please note, it is possible to use different time intervals. If you’re going to use more than a one-month interval between the front-month and back-month options, you need to understand the ins and outs of rolling an option position.
Options Guy's Tips
Ideally, you want some initial volatility with some predictability. Some volatility is good, because the plan is to sell two options, and you want to get as much as possible for them. On the other hand, we want the stock price to remain relatively stable. That’s a bit of a paradox, and that’s why this strategy is for more advanced traders.
To run this strategy, you need to know how to manage the risk of early assignment on your short options.
- Sell an out-of-the-money put, strike price B (near-term expiration – “front-month”)
- Buy a further out-of-the-money put, strike price A (with expiration one month later – “back-month”)
- At expiration of the front-month put, sell another put with strike B and the same expiration as the back-month put
- Generally, the stock will be above strike B
Who Should Run It
Seasoned Veterans and higher
NOTE: The level of knowledge required for this trade is considerable, because you’re dealing with options that expire on different dates.
When to Run It
You’re expecting neutral activity during the front month, then neutral to bullish activity during the back month.
Break-even at Expiration
It is possible to approximate break-even points, but there are too many variables to give an exact formula.
Because there are two expiration dates for the options in a diagonal spread, a pricing model must be used to “guesstimate” what the value of the back-month put will be when the front-month put expires. Ally Invest’s Profit + Loss Calculator can help you in this regard. But keep in mind, the Profit + Loss Calculator assumes that all other variables, such as implied volatility, interest rates, etc., remain constant over the life of the trade — and they may not behave that way in reality.
The Sweet Spot
For step one, you want the stock price to stay at or around strike B until expiration of the front-month option. For step two, you’ll want the stock price to be above strike B when the back-month option expires.
Maximum Potential Profit
Profit is limited to the net credit received for selling both puts with strike B, minus the premium paid for the put with strike A.
NOTE: You can’t precisely calculate potential profit at initiation, because it depends on the premium received for the sale of the second put at a later date.
Maximum Potential Loss
If established for a net credit, risk is limited to the difference between strike A and strike B, minus the net credit received.
If established for a net debit, risk is limited to the difference between strike A and strike B, plus the net debit paid.
NOTE: You can’t precisely calculate your risk at initiation, because it depends on the premium received for the sale of the second put at a later date.
Ally Invest Margin Requirement
Margin requirement is the difference between the strike prices (if the position is closed at expiration of the front-month option).
NOTE: If established for a net credit, the proceeds may be applied to the initial margin requirement.
Keep in mind this requirement is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.
As Time Goes By
For this strategy, before front-month expiration, time decay is your friend, since the shorter-term put will lose time value faster than the longer-term put. After closing the front-month put with strike B and selling another put with strike B that has the same expiration as the back-month put with strike A, time decay is somewhat neutral. That’s because you’ll see erosion in the value of both the option you sold (good) and the option you bought (bad).
After the strategy is established, although you want neutral movement on the stock if it’s at or above strike B, you’re better off if implied volatility increases close to front-month expiration. That way, you will receive a higher premium for selling another put at strike B.
After front-month expiration, you have legged into a short put spread. So the effect of implied volatility depends on where the stock is relative to your strike prices.
If your forecast was correct and the stock price is approaching or above strike B, you want implied volatility to decrease. That’s because it will decrease the value of both options, and ideally you want them to expire worthless.
If your forecast was incorrect and the stock price is approaching or below strike A, you want implied volatility to increase for two reasons. First, it will increase the value of the near-the-money option you bought faster than the in-the-money option you sold, thereby decreasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the upside).
Exercise, Assignment and Spreads
Posted by Pete Stolcers on March 10, 2009
Option Trading Question
Today Rick W. asks, “I don’t understand what I’m supposed to do when I have a spread and I get assigned on one leg of the trade.”
Option Trading Answer
This is an involved piece. First let me define two terms. Exercise is what the buyer of an option does. They use their right to buy or sell a stock at a specific price. Assignment is what happens to the seller of an option when they are forced to buy a stock or sell a stock at a certain price. If you are long an option you have rights, if you are short an option, you have an obligation.
Let’s say that you are short the 50 - 45 put credit spread and the stock (ABC) is trading at $43 - ouch. It doesn’t matter what you sold it for, this can’t be a good trade. If the 50 puts are trading for $7 (parity) you run the risk of being assigned. If the traders who are long the puts decide to exercise their right to sell the stock at $50, the Options Clearing Corporation (OCC) determines which firms will be assigned and each brokerage firm has a standardized lottery process to determine how the assignment will be allocated across the accounts. As long as the 50 puts carry some premium, this risk is minimal. The reason is simple, the owner of the puts can get more by selling them in the open market.
You come in one morning and you are long ABC stock via overnight assignment of the $50 puts. You have three choices. One choice is to sell the stock and sell the put again. Bad move. Never do this. The options are already trading under parity and now that the option is in play, you will probably get assigned again. The second choice is to exercise the 45 puts that you are long. This action allows you to sell an equal number of shares that you are long. If you were assigned on 5 puts and you are long 500 shares, you would exercise 5 of the 45 puts. Now you are “flat” the stock and if you do it the same day, you are exempt from having to put up the margin for the long stock (rule: same day substitution). This action makes sense if the stock is trading below $45. The third choice is to simply sell the stock in the open market if it is trading above $45. If it is done the same day, it also qualifies for the margin exemption.
If the risk scares you, you can always place an order to buy the spread in for $5. That is the max that it can ever be worth and you should not pay more than that no matter what the screen (bid/ask) shows. I do not advocate doing this because in essence you are giving someone a free call. They sell the spread for $5, the most it can be worth. If the stock reverses, they will participate in the rally - WITHOUT TAKING ANY RISK.
The risks and approach are much different for cash settled products like the OEX. That might be a future article. A stock that is closing right at the strike of the cheap leg of a spread on expiration Friday also creates a problem that will be covered in the future.
If you are having issues with a position this expiration, post a comment and let’s take a look.