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Stocks & Commodities V. 27:4 (34-41): A Flexible Strategy For Volatile Markets by John Manley
Checkmate
A Flexible Strategy
For Volatile Markets
Profit from option spreads on the S&P 500 by applying the 500 (SPY) through the exchange traded fund (ETF). Heres a
JESSICA MAZURKIEWICZ
same tactic as you would playing chess. Heres how. breakdown and analysis of a real strategy.
METASTOCK
ther-month options at one strike
and sell the same amount of op-
tions at a different strike in the FIGURE 1: PRICE CHART OF SPY. The SPYs were in the process of testing the lows made two months earlier in January
2008 around the 126127 levels.
front (closest) month. This al-
lows us to profit over a range of
prices over time, and the spread
can be morphed into other strat-
egies to take advantage of chang-
ing market conditions.
As with any trade, whether it SPY Strategy and
adjustments overlay
is a directional speculative play
1.618 148.54
or a defined-risk spread, strict
money management rules ap-
ply. If our stop-loss is hit, it is
necessary to shut the play down. 1.272 143.69
Here is the initial action. See Profit range - add call diagonal
strategy diagram (Figure 2): spread to put diagonal spread
INITIAL GREEKS OF
SPREAD
Delta: 206.
Slightly bullish;
we are initially
synthetically long
206 shares, and
Put diagonal SPY Mar 14 this will diminish
as prices rise and
get longer as
prices fall
Theta: $60.
Working in our
Current price favor; dollar
amount deposited
FIGURE 3: PROFIT & LOSS DIAGRAM. Here you see that over time, there is a fairly large profit zone, with approximately a 4.8% to our account on
downside protection initially. If the SPY moves higher over time you will benefit and have decent profits and protection to the downside a daily basis. This
over time.
will change as
prices up and down. They are: price moves, time passes, and volatility changes
Delta (price movements) Vega: $172. Long volatility; will help on a fall in prices
and hurt profit to a certain degree on a rise in prices. I was
Theta (time value; we are positive theta meaning you
not expecting a complete volatility collapse in the mar-
are profiting daily as time moves forward)
ket environment, and delta/theta movements should
Vega (changes in the implied volatility of the option compensate for some volatility offset. Key relationships
legs. The put diagonal is long volatility, meaning a rise between front- and back-month vega and theta will be
in implied volatility will add profits to the position and affected by changes in volatility, which we will address:
a fall will hurt).
Initial lower breakeven (put diagonal) on expiry: 123.50
I was looking at this overall play as a possible three-part (-4.8% downside protection initially)
strategy with the idea of morphing the original play to the
Initial upper breakeven (put diagonal) on expiry: 146.00
downside and to the upside, should the technical picture
(12.6% upside breakeven).
support that. I wanted to let the market show its hand first.
As you can see from the P&L diagram in Figure 3, there is
PRICING a fairly large profit zone over time, with an approximate 4.8%
Three key greek (pricing components of options) interrela-
downside protection initially. You will benefit if the SPY
tionships are involved with this series of plays. One of the
moves higher over time and you have decent profits and
most important is the delta (price movement). As the market
protection to the downside over time.
begins to move around, we are going to monitor our position
delta and make adjustment decisions based on the constraints
TRADING PLAN
I had set for the spread. A key characteristic of the put
Scenario 1: The markets break support and push lower
diagonal is that as prices fall, the delta gets larger, meaning
Heres how to make a couple of simple maneuvers to the
we are synthetically acquiring more shares with a price drop
existing spread and profit from lower price zones, should the
just the opposite of what we would want to happen. When
markets want to play there and extend your downside
prices rise, we are synthetically selling more shares short.
breakeven to more than 9% from current beaten-down prices.
Again, just the opposite of what we would like to see happen,
I initiated the strategy on Friday, March 14, 2008, with the
but that is the tradeoff for having positive theta (time value
put diagonal. By Monday, things were looking ugly for the
that is, deposits of eroding premium are credited to our
markets as emergency actions were taken over the weekend
brokerage account every day).
by the Federal Reserve to deal with the collapsing Bear
With option spreads there are a number of morphing,
Stearns. As a result, the Asian markets had sold off hard on
adjustment, and synthetic possibilities. The series presented
Sunday and by Monday morning the index futures in the US
here highlights just one of many prospects. The adjustments
were pointing to a big down day.
were chosen based on the markets technicals, volatility
As the market pushed to new lows on March 17, I modeled
readings, and passage of time during the selected period.
out morphing the original put diagonal into double calendar
5,000
the diagram in Figure 4 illustrates.
0 This move will decrease your po-
118.88 119.00 120.00 122.00 122.00 123.00 124.00 125.00 126.00 127.00 128.00 129.00 130.00 131.00 132.00 133.00 134.00 sition delta, making it much less sen-
-5,000 Breakeven shift from 123 to 118.50 sitive to price movements, increase
Original strategy
theta, meaning greater erosion of time
-10,000
premium on a daily basis and thus
-15,000 deposits to your account, and in-
Underlying asset price
crease vega sensitivity to changes
FIGURE 4: MORPHING INTO DOUBLE CALENDAR SPREADS. You reverse the process by shorting April 124 puts and in volatility, which you can also
going long June 129 puts. This shifts the entire profit zone lower. hedge. The risk profile of the trade
(Figure 5) also changes because you
are adding a new position. With this
spreads (calendar spreads are time spreads also but with the model, your dollars at risk actually decrease by $600 with the
same strike prices in the front and back month). This move morphing to calendars.
will shift the strategy lower but still give a range of profitabil- In the comparison diagram in Figure 5, you can see that this
ity up and down the price spectrum. At the time, I was just strategy shift moves your initial lower breakeven down to the
testing the waters to see what the shift would look like. If the 118 area from 123, giving you almost another 7% protection
SPY took out the low and continued to press to the 124 area from the 126.55 area. It also expands your profit potential at
(our long strike), I would have begun the morphing process. these lower prices by a wide margin and still gives an upper
The model uses actual market prices and volatilities at the breakeven about 8% above current prices (around the 136
time it was created. With the selloff that day, the VIX was area).
spiking up. I had a feeling much of the volatility spike was This is the initial defensive move. If the market structure
being forced on the front-month options. I wanted to see if we really wanted to play at lower levels, you could add another
did have a volatility skew between the front and back month calendar series below the 124 level around 120. This
when morphing to double calendars. Sure enough, we did would give you a breakeven around the 114 area for April
about a 4% skew, making the initial adjustment that much more expiry. One of the caveats of these adjustments is how much
attractive. time has elapsed since the original strategy was put on. As we
The mechanics of a put diagonal morphed into double get closer to the April expiry, adjustments may have less
calendar spreads: Our original put diagonal starts off by effect as the premium is eroding. If enough time has gone by,
shorting the April 129 puts and buying the June 124 puts. To however, there is also a good chance that profits have built up
morph it into double calendars, you reverse the process by in the original strategy.
shorting April 124 puts and going long June 129 puts. This
Scenario 2: The SPYs
surge higher
Since establishing the
original spread, no ad-
justments have been nec-
essary. As of Wednes-
day, March 26, the origi-
nal put diagonal showed
Volatility skew on front an unrealized gain of
month options (April)
14.6% or $1,689 (see
Figure 6) over a 12-day
period (this snapshot was
Put diagonal morphed taken during market
into double calendar hours). The profits have
mostly come from the
erosion of time (theta)
and price movements
(delta). In that time,
prices have moved from
a low of 126.07 to a high
of 135.81. Prices were
FIGURE 5: CHANGE IN RISK PROFILE. The risk profile changes because you are adding a new position. With this model your dollars around the 133 area on
at risk actually decreases by $600 with the morphing to calendars. March 26, 2008. Re-
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 27:4 (34-41): A Flexible Strategy For Volatile Markets by John Manley
OPTIONS
REDUCE STRESS
AND INCREASE
PROFITS
With a double diagonal
in place, you would
have unrealized profits
built in, a large profit
FIGURE 7: CALL DIAGONAL SPREAD. If the SPY pushed through the 50-day MA, I would have looked at establishing an April/June
range up and down the
call diagonal spread to complement the put spread essentially creating a double diagonal. This would shift profit to higher strikes and price spectrum for a
show a break even around 9% above current prices.
short-term play, and the double diagonal could be morphed John Manley is a professional derivatives trader and man-
into other strategies to address changing market conditions ages a private derivatives-based hedge fund for a group of
going forward. high net worth individuals. The portfolio returned 28% in
You can continue to sell short strikes each month against 2008 and is up 100% since its inception a little over three
the back-month long premium and eventually morph the years ago. He also engages in advisory and educational
double diagonal into a short iron condor or even double services for individuals and ins titutions on the proper use of
butterflies (to change the IV outlook and use profits from exchange traded options for superior portfolio returns and
double diagonal to completely take the risk out of the morphed risk management. He holds the Derivatives Market Specialist
position). designation from the Canadian Securities Institute.
All in all, these strategy scenarios can be flexible, low-
stress ways to profit over a large price range with the passage
of time. S&C
Interactive Brokers
Member - NYSE, FINRA, SIPC Supporting documentation for any claims and statistical information will be provided upon request.
*According to Barrons best online broker review on March 9, 2015, How Secure Is Your Securities Portfolio. Lowest cost of any broker and
Best Trading Experience & Technology in Barrons survey. For more info see ibkr.com/awards. Barrons is a registered trademark of Dow
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