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Yowster

GMCR diagonal trade after big drop today

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GMCR dropped over 8% today after the announcement of their new KOLD machine did not exactly impress anyone.  So, I wanted to construct a short term trade to benefit from some more downside over the next few weeks.  Because a big drop is possible IMO I wanted a trade that will not lose if the drop is bigger than I expect (so I ruled out flies and calendars) and one that I can easily adjust if I'm wrong and GMCR starts to rise.  I decided on using a diagonal trade where with GMCR around 94.50 this afternoon I bought the May29 94 put and sold the May22 93 put for a debit of 0.92. 

  • Best case is if GMCR drifts down a few more dollars over the next week, and then I'll close the trade as it stands late next week.  Could be around a 100% profit if its near 93 at the end of next week.
  • If the bottom falls out and GMCR drops a lot, then my diagonal will likely be worth a few cents over 1.00 - and since I paid 0.92 for it, then I'll still make a modest profit.
  • If I'm wrong and GMCR starts to rise then I'll roll my short 93 put to the 94 put turning the trade into a 94 call calendar.

We'll see how it plays out.  I think the only way I'll lose big is if GMCR stock price spike up significantly.

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Interesting setup. But if the stock rebounds to 97-99, your loss will be over 50%.

 

Very true, but much less $$$ loss than if he shorted 100 shares of stock ($45 loss on his spread vs $400 loss on the short stock).  This is a great use case for options.

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Interesting setup. But if the stock rebounds to 97-99, your loss will be over 50%.

Yup, that's the risk...  but if it gets to the 97-99 range slowly then I should be able to adjust the diagonal to a calendar and minimize the loss a little.  A sudden spike to that price is the worst case.  Its definitely a speculative trade and since my best case profit target% is high I'm using a small allocation.

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You got the direction right, so the trade has worked in your favor. Now you can count your profits . 

How much it is now ?

What is max profit ?

How long you intend to hold for max or % of max profit  ?

Trade is up about 20% now, GMCR  actually fell more than I thought - but its why I chose the diagonal trade structure as I thought a bigger drop was possible.  Ideally, I want GMCR to be around 93 at the end of the week for a 100% or more profit.  But now that it dropped so much in one day, I'll hang on for a bit until some of the time premium drops out of the short 93 put and/or GMCR gets closer to 93.  If it drops into the 80's and stays there then I'll probably close the trade for like 15% profit.

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With GMCR below 90 for the last couple of days, I closed this trade today.   I closed the diagonal for 1.25 for a 36% gain, this is actually better than I anticipated given that GMCR had fallen well below my short 93 strike - but since GMCR options have relatively high IV there was still enough time premium in my May29 94 puts to allow me to get 1.25 even though the strike differential was 1.00 in the diagonal.  I was thinking GMCR would have a less substantial drop this week, but with the diagonal trade structure I was able to make a nice gain even though the drop was much higher than I thought.

 

I did the same thing with WMT after its post-earnings drop, buying the May29/May22 77.5/76.5 put diagonal yesterday morning for 0.72 (I didn't post that one in the forum because within 15 minutes of me making the trade WMT dropped some more and the trade was already up over 10%, so I didn't want anyone to jump in at a price much higher than mine).  That trade is currently up a little over 30%, but I'm still holding and hoping to close for 1.00 or more by the end of the week.

 

I'm liking this trade structure as a post-earnings (or post-event) directional trade when a stock has clear momentum in either direction - it can make gains if the stock price stays steady, moves a little in either direction or moves a lot in your direction, and you can adjust if the stock price gradually starts moving against you.  The bigger loss scenario is when you get a quick and large move in the opposite direction, which is why I think the best time to trade it is when you get an outsized stock price move where a clear directional momentum is established.   This may also be a good structure for VXX trades where the momentum is almost always downward - the BWB or 1x3x2 all start to lose if the VXX drops too much in your timeframe, so a VXX diagonal may work well although will have do some more analysis on this.

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HI Yowster, 

 

How would this strategy compare with just establishing a ATM credit or debit spread ?

I believe the ATM credit/debit spread could have bigger gains but same max loss as diagonal ?  Also the IV will keep coming off which can help the credit/debit spreads while it can hurt the diagonal .

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HI Yowster, 

 

How would this strategy compare with just establishing a ATM credit or debit spread ?

I believe the ATM credit/debit spread could have bigger gains but same max loss as diagonal ?  Also the IV will keep coming off which can help the credit/debit spreads while it can hurt the diagonal .

"ATM credit or debit" spread is a little vague, so without a specific example here is how I would compare:

  • ATM spreads where your long leg is slightly ITM and the short leg is slightly OTM would typically lose or break even if the stock does not move.  The diagonal would have a nice gain if the stock does not move.  With the debit spread in particular, you need the stock to move in your direction to be successful, but with the diagonal you do not.
  • A credit/debit spread typically involves both legs having the same expiration and if the stock moves in your opposite direction there is not a real good adjustment option.  With the diagonal if the stock starts moving against you, you can adjust by turning it into a calendar.
  • The IV typically does not keep coming off as most of that has already happened after the event - and even if the IV does fall, since you are both long and short strikes in different expirations the IV changes will basically offset each other.  The diagonal is more like a calendar is that its a play on the theta working in your favor - the vega is not a concern in that post-event its unlikely that IV will affect your short leg to a greater degree than it would the long leg.

I would compare the diagonal structure to a calendar, not a credit/debit spread.   It is basically a calendar, but with a directional bias.   Since the strikes are relatively close to each other, the trade will make money if the stock price stays the same or moves a little in either direction (obviously will make a lot more if it moves in the right direction).  But, unlike a calendar, the trade will still make a profit it you get an outsized move in the correct direction.

Edited by Yowster

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Hi Yowster,

 

May be you can backtest  using a debit spread with same strikes as your diagonal to verify  which one performed with best gains ?

 

Say in your case  94-93 put debit spread  where 93 is short leg.

Try to compare both week expirations and with your diagonal to see which one worked best ?

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Hi Yowster,

 

May be you can backtest  using a debit spread with same strikes as your diagonal to verify  which one performed with best gains ?

 

Say in your case  94-93 put debit spread  where 93 is short leg.

Try to compare both week expirations and with your diagonal to see which one worked best ?

This would be an apples vs oranges comparison.  Obviously, with the big downward move the 94-93 put debit spread would have had a higher gain percentage using either week expiration.  But that debit spread needed the stock to move downward to be successful - if the stock stayed the same or rose then the spread would lose.  If I KNEW the stock was going to go down then debit spread would have been the trade to make.   However, when I placed the trade I wanted to construct something that would work if the stock fell a lot, fell a little, stayed the same or even rose a little - and also gave me the ability to adjust if it continued to rise.  My one substantial loss scenario would come on a big price spike in the wrong direction.

 

Whenever I make an options trade I try to make it have multiple profit scenarios - the diagonal structure gave me that.  With debit spreads you basically have one winning scenario and that is to have the stock move in your direction.

Edited by Yowster

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This would be an apples vs oranges comparison.  Obviously, with the big downward move the 94-93 put debit spread would have had a higher gain percentage using either week expiration.  But that debit spread needed the stock to move downward to be successful - if the stock stayed the same or rose then the spread would lose.  If I KNEW the stock was going to go down then debit spread would have been the trade to make.   However, when I placed the trade I wanted to construct something that would work if the stock fell a lot, fell a little or even rose a little - and also gave me the ability to adjust if it continued to rise.  My one substantial loss scenario would come on a big price spike in the wrong direction.

 

Whenever I make an options trade I try to make it have multiple profit scenarios - the diagonal structure gave me that.  With debit spreads you basically have one winning scenario and that is to have the stock move in your direction.

Thanks for the additional information on this trade. It makes a lot more sense to me now.

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I believe you should backtest to check the numbers out. 

with the short leg of debit spread ATM . It will make money as the short legs premium dissipates while the stock stays put at that price. 

so it should make money the same way as diagonal if the stock stays put or even moves up a little bit.

 

The credit/debit spread will give more bang for the risk ( 50% gain for similar risk) , if the stock really takes off in anticipated direction.

 

I agree that you should always look for multiple profit scenarios, but when you are putting a  calendar/diagonal, your profit scenario is if IV increases, but that is not going to happen after earnings.

More likely IV will decrease.

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I believe you should backtest to check the numbers out. 

with the short leg of debit spread ATM . It will make money as the short legs premium dissipates while the stock stays put at that price. 

so it should make money the same way as diagonal if the stock stays put or even moves up a little bit.

 

The credit/debit spread will give more bang for the risk ( 50% gain for similar risk) , if the stock really takes off in anticipated direction.

 

I agree that you should always look for multiple profit scenarios, but when you are putting a  calendar/diagonal, your profit scenario is if IV increases, but that is not going to happen after earnings.

More likely IV will decrease.

I disagree with basically everything you say here.  Backtesting the 2 trades versus each other has no merit as they are two totally different trade structures with different profit/loss scenarios.  Your best case profit is 50% if you get the move in the right direction, but the best case profit was around 100% for the diagonal if  it wound up near my short strike at the end of the week.   You also keep referring to the IV impacting the diagonal, but the reality is that any IV impact will be minimal as the post-event IV changes are likely going to be minimal and will impact both legs virtually the same - as I said before theta is what helps this trade and since my short leg is expiring within a week the positive effects of theta will overshadow any IV effect.   IV changes is of minimal impact to this trade yet you portray it as a big factor.

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I believe you should backtest to check the numbers out. 

with the short leg of debit spread ATM . It will make money as the short legs premium dissipates while the stock stays put at that price. 

so it should make money the same way as diagonal if the stock stays put or even moves up a little bit.

 

The credit/debit spread will give more bang for the risk ( 50% gain for similar risk) , if the stock really takes off in anticipated direction.

 

I agree that you should always look for multiple profit scenarios, but when you are putting a  calendar/diagonal, your profit scenario is if IV increases, but that is not going to happen after earnings.

More likely IV will decrease.

You need to remember that most of the IV collapse is in the first couple hours after earnings. As a general comment, for short term trades, the theta and the gamma are much more important than the vega.

 

As Yowster mentioned, those are completely different trades. The diagonal gives you some caution even if you are wrong. The debit spread doesn't. The diagonal will make money if the stock is unchanged. The debit will NOT. In fact, it NEEDS the stock to go down.

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Love this of trade. Maybe we should discuss what stocks will be target slow droppers and have a running list?

I know some that drop slowly, but move up and down in a narrow channel ( Twitter, Yelp ). But, they may spike any day.

Bestbuy is also kind of lame that way.

But at least they move slowly for now.

Oil drilling company stocks drop slowly each time oil dips below $60.

But, maybe these are all too risky.

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Deftone,

 

I constructed this trade as a short term, one-week play on continued momentum after an oversized move post-event (earnings, announcements).  That is why I used all short-dated expirations.  I did it on the downside with puts but could also do on the upside with calls.  Both trade were successful GMCR +36% and WMT +43%, but both continued in the desired direction post-event.  So,  I'm keeping my allocations relatively small on these trades until I see how some behave when the price action goes against me and I have to adjust.

 

What you outline in your post is more of play on a longer-term price trend up or down.  While you could use this trade structure for this, there is no short-term momentum to play in this situation, so for these type of long-running trades I typically use a slightly different structure - for stocks in a long-term uptrend I buy a deeper ITM longer dated call (typically delta of 70 or more) and then sell a short-dated weekly or monthly call against it.  If the short call gets really cheap then I'll roll it to out to another expiration/strike based on where the stock price is at that point in time.  If the stock price moves above my short strike near the short leg expiration then I'll roll up both the short and long legs.  You can also do the same type of trades using puts for stocks in a downtrend.  Some weeks/months you'll make more than others but if the stock generally continues in your direction then you'll make out well.  The tough part is determining when the stock breaks the longer term trend and its time to take off the trade.

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