General Questions on the DITM Double Diagonal

[cwelsh 1,550]

it was wisely pointed out that it would be nice to have a general thread about these DITM double diagonal's (long income) strategy being employed.

So here it is! If you have any questions related to the strategy generally, identify another instrument you think will work well, or just generally want to discuss it, post here.

[Rogers 263]

Is it possible to have a place to see a snapshot of your current DITM positions? At least for the ones you have presented here (AAPL,SNDK,XOM,APA,VXX,GLD)

[cwelsh 1,550]

Sure, and I'll start posting an end of the week update Friday or Saturday of all my current DD positions. I will also post NET of commissions so people have a better understanding of how commissions play a role. Also, I will post the "cumulative" return on the trade, net of commissions, and for how many weeks its been running. Lastly, I'll include the "max" loss on the long positions. The max loss occurs, if held to expiration and the expiration is anywhere between the long strangle strikes or exactly at one of the long strikes. If it's past one of the longs, then you actually gain more. Note that only by holding to expiration is the worst case realized. This should NEVER happen with one of these trades. However, it is useful to note the worst case to know what type of returns you need on the short to cover potential drops in volatility.

So for instance, if I earned 2.7% on the VXX in week one, and 2.5% in week two, the "net" return reported below would be 5.2% (there is no compounding). However, pay attention to the longs, because they probably will have dropped in value some.

Please note that I do have a negotiated lower commission schedule than the "advertised" TDAmeritrade commissions. (If you don't call and ask, they will for sure lower some, and depending on the size of your account, might lower it significantly -- please do not post commission questions, unless it relates to the DD trade directly, in this column -- there's already a thread for that).

APA

Jan 72.5 Call

Jan 90 Put

Cost: $19.63

Max loss on long: $2.13 (10.85%)

Net returns: 1.8% week 1, in week 2

GLD

Jan 159 Call

Jan 178 Put

Net Cost: $22.12

Maximum loss on the long position: $3.12 (14.1%)

Currently in week 1, (0% net return)

SNDK

Dec 38 Call

Dec 47 Put

Net Cost: $10.71

Max possible loss on long: $1.71 (15.9%)

Return: 2.98% week 1, 0.04% week 2, in week 3 (cumulative 3.02%)

VXX

Jan 30 Call

Jan 41 Put

Cost: $16.40/strangle

Max Possible loss: $5.40 (32.9% -- because of this, we probably will close this one 2 weeks earlier than normal -- so mid-dec)

Net Return 4.78% in week 1, 3.82% week 2, currently in week 3 (8.6% cumulative)

XOM

Jan 85 Call

Jan 95 Put

Cost:$11.65/strangle

Max Possible loss on long: $1.65 (10%)

Net return: 0%, currently in first trading cycle

The VXX is what I'm keeping the closest eye on, as not being right at .80 delta or better on the longs might bite us in the end. If so, we'll just have to fix going forward. Right now we are still up, even with the decline. but again, bears watching.

I'm swamped at work too -- so I'm going to have to verify my above calculations tomorrow. If there's an error, please send me a PM (not on this thread), and I'll go and edit.

[cwelsh 1,550]

Not in appl yet, probably Thursday

[Rogers 263]

Thank you Chris.. I have to admit that these are tough trades in the current market... But I think it's a nice addition to an income portfolio.

[cwelsh 1,550]

Increased volatility and swings does make these tougher trades, but I wanted diversity from just earnings income, and so far, this is the best I've come up with.

I was backtesting IWM today, and came across an interesting scenario I wanted people's opinions on.

Assuming we started last week, going with the standard .80, you could enter the Jan 72 call and 85 Put for $14.68, for a max loss of $1.68 on the longs (11.44%).

Or you could go closer in on the 74 call and 83 put for $11.42, with a max loss of $2.42 (21.2%)

Or you could go even further in on the 76 and 82 for $9,25, with a max loss of $3.25 (35.1%).

Typically I want to go with the smaller losses, as you will lose theta over time, and with high deltas that happens less. HOWEVER, the ideal strikes on the shorts on this is in the .25 range, and you should make about 0.60/week. So if opening the prior week, you'd be selling the 77 and 81 for .59 -- just barely inside your longs.

If you did that though, you'd be pretty protected against a BIG move one way or the other. If IWM behaves, and stays between, you keep the .59 (which is a very nice return at the 9.25 level, less so at the $14.68). If you have a wild swing one day, then your long position actually gains value to offset some of the losses on the short.

I haven't backtested the closer in strikes, I'm generally thinking its a bad idea, but I would like everyone's thoughts -- I just think over the longer term theta will eat you alive.

Edited November 15, 2012 by cwelsh

[Rogers 263]

The 76/82 is attractive to me because it ties up less capital.. Selling the 77 put seems really scary seeing that we closed at 77.39 today

Edited November 14, 2012 by Scott Rogers

[cwelsh 1,550]

The 76/82 is attractive to me because it ties up less capital.. Selling the 77 put seems really scary seeing that we closed at 77.39 today

Whereas I view that as a good result -- large decline, and the 77 is still only valued at .44. That means, minus a BIG gap down tomorrow, it'll be a profitable roll.

The way I view this is:

a) less capital up front, larger weekly returns, more protection against BIG moves, BUT you're really guaranteeing a theta loss on the longs over time -- how much, don't know haven't backtested yet. You will also have more adjustments necessary of the longs.

OR

minimal theta loss, but larger capital outlay, and smaller weekly returns

(writing this out helps me think through) -- I think I just need to backtest both scenarios and see if the theta loss is too much.

[csensen13 1]

Chris, I really like your strategy ideas and appreciate the work and effort you put into them. I'm trying to get my head around all these possible scenarios and to understand the numbers, since it's always a numbers game.

The max loss is the difference between the range of your long positions and the price you're paying to open up the position. So, in that case for the IWM example you're referring to above, the first calculation appears correct, but the other 2 seem a bit off:

for the 72 call/85 put @ 14.68, the max loss would be 14.68-13 = 1.68, which is 11.44%, as you mention.

for the 74 call/83 put @ 11.42, the max loss would be 11.42 - 9 = 2.42 or 21.2%

for the 76 call/82 put @ 9.25 the max loss would be 9.25 - 6 = 3.25 or 35.1%

I just want to make sure I understand the calculations properly, but after all, as you said, these would be the worst case scenarios and the point of the strategy is not to hold until expiration, obviously.

Other than that, I think that in this sudden high volatility climate we've been in for the past week, any of these strategies would probably require a lot of management/rolling/readjustments, so probably the one using up the lesser amount of capital could be the more attractive one.

Anyway, thanks for your ideas.

Carlo

[Kelly Park 10]

I think we need to be careful when thinking that we are in a high volatility environment now. It has come up a bit in the last couple of weeks, but VIX is still well below 20. I am hoping that at some point we will be getting back to a more consistent return on our pre-earnings trades. But I am concerned that these double diagonals, which are working quite well now, may go south as volatiltiy returns. We haven't seen that yet. In your backtesting, Chris, are you using times of higher and lower VIX, to see if these trades hold up under different volatility conditions? I don't want to get excited and start increasing allocations, only to find that conditons have changed and it doesn't work anymore.

[cwelsh 1,550]

Chris, I really like your strategy ideas and appreciate the work and effort you put into them. I'm trying to get my head around all these possible scenarios and to understand the numbers, since it's always a numbers game.

The max loss is the difference between the range of your long positions and the price you're paying to open up the position. So, in that case for the IWM example you're referring to above, the first calculation appears correct, but the other 2 seem a bit off:

for the 72 call/85 put @ 14.68, the max loss would be 14.68-13 = 1.68, which is 11.44%, as you mention.

for the 74 call/83 put @ 11.42, the max loss would be 11.42 - 9 = 2.42 or 21.2%

for the 76 call/82 put @ 9.25 the max loss would be 9.25 - 6 = 3.25 or 35.1%

I just want to make sure I understand the calculations properly, but after all, as you said, these would be the worst case scenarios and the point of the strategy is not to hold until expiration, obviously.

Other than that, I think that in this sudden high volatility climate we've been in for the past week, any of these strategies would probably require a lot of management/rolling/readjustments, so probably the one using up the lesser amount of capital could be the more attractive one.

Anyway, thanks for your ideas.

Carlo

Absolutely correct, I rarely have time to check calculations while typing out thoughts -- so always appreciate the catches

[cwelsh 1,550]

I think we need to be careful when thinking that we are in a high volatility environment now. It has come up a bit in the last couple of weeks, but VIX is still well below 20. I am hoping that at some point we will be getting back to a more consistent return on our pre-earnings trades. But I am concerned that these double diagonals, which are working quite well now, may go south as volatiltiy returns. We haven't seen that yet. In your backtesting, Chris, are you using times of higher and lower VIX, to see if these trades hold up under different volatility conditions? I don't want to get excited and start increasing allocations, only to find that conditons have changed and it doesn't work anymore.

I back tested the instruments I'm in over a three year period (started with two and then went back another) -- so January 2010 through the present. The instruments I traded performed quite well over that extended period -- that's not to say they money in each and every six-eight week cycle, but that they demonstrated a very positive return over time.

Before I commit a much larger allocation, I need to do a FULL backtest across all market conditions, that means specifically test:

1999-2001

2008

To the extent data is available. If these still work over that period, I'll allocate a much larger portion. When will that happen? No clue, maybe thanksgiving.

[cwelsh 1,550]

The updates for the current positions and profitability:

APA

Jan 72.5 Call

Jan 90 Put

Cost: $19.63

Max loss on long: $2.13 (10.85%)

Net returns: 1.8% week 1, -3.1% in week 2, currently in week 3 at 72.5/77.5

GLD

Jan 159 Call

Jan 178 Put

Net Cost: $22.12

Maximum loss on the long position: $3.12 (14.1%)

Week 1 was a 3.7% gain, in week two in the 164/168.5

SNDK

Dec 38 Call

Dec 47 Put

Net Cost: $10.71

Max possible loss on long: $1.71 (15.9%)

Return: 2.98% week 1, 0.04% week 2, week 3 was a -2.5% loss, currently in the 38/40.5

VXX

Jan 30 Call

Jan 41 Put

Cost: $15.85/strangle (averaged down week 3)

Max Possible loss: $5.40 (32.9% -- because of this, we probably will close this one 2 weeks earlier than normal -- so mid-dec)

Net Return 4.78% in week 1, 3.82% week 2, week 3 was a 1.2% gain, currently in the 34/39

XOM

Jan 85 Call

Jan 95 Put

Cost:$11.65/strangle

Max Possible loss on long: $1.65 (10%)

Loss 4.1% week 1, currently in 82.5/87.5

Over all this week was quite bad. However, week over week (last Thursday when opening through today) the S&P 500 was down almost 2.5% -- considering over the last ninety days the average seven day move on the S&P was just under half a point -- I'm actually quite happy with the results. XOM was by far the worst -- but that's entirely my fault. I saw the middle east blowing up and said "Oh, oil will rebound, so I'll just hold the position until XOM does as well" -- again violating my own rules, making a directional bet. If I had closed it when the short strike hit, it would have been a 0.4% loss. My SNDK trade was worse than necessary as well, I had my alerts up, but could not react due to other work, so had to close out a day later, at a worse price, that one should have still been a gain (as at least one member successfully did). Looking back, even if I had a stop loss order in and been filled at the asking price, I STILL would have had a profit (tiny one).

Moral of the story: (a) stick to the rules and don't outthink the market, and ( if you won't be around, stop losses might not be a bad idea positioned at or right below the short strikes. I'm going to look into this further. Normally alerts are fine for me because I can almost always get to a computer, but if I can't having stop losses might be necessary.

Edited November 16, 2012 by cwelsh

[Kelly Park 10]

I've been thinking about stop losses on these for the same reason. I haven't quite sorted out how to do it on IB, so if anyone has any suggestions, I'm all ears. Been wondering if the stop loss should trigger with a set price on the underlying, OR with a percentage of the credit received. Leaning toward the latter, but not sure where to set.

[cwelsh 1,550]

APA

Jan 72.5 Call

Jan 90 Put

Cost: $19.63

Max loss on long: $2.13 (10.85%)

Net returns: 1.8% week 1, -3.1% in week 2, 2.33% week 3, (up 1.03% overall so far)

Current Position: 75/80, max 2.4%

GLD

Jan 159 Call

Jan 178 Put

Net Cost: $22.12

Maximum loss on the long position: $3.12 (14.1%)

Week 1 was a 3.7% gain, Week 2 was a 3.8% gain, (up 7.5% overall)

Current position: 166/170 for a max of 3.67% gain

SNDK

Dec 38 Call

Dec 47 Put

Net Cost: $10.71

Max possible loss on long: $1.71 (15.9%)

Return: 2.98% week 1, 0.04% week 2, week 3 was a -2.5% loss, week 4 was a 6.8% gain (up 7.32% overall)

Current Position: 38.5/41 for a max 5.34% gain

VXX

Jan 30 Call

Jan 41 Put

Cost: $15.85/strangle (averaged down week 3)

Max Possible loss: $5.40 (32.9% -- because of this, we probably will close this one 2 weeks earlier than normal -- so mid-dec)

Net Return 4.78% in week 1, 3.82% week 2, week 3 was a 1.2% gain, week 4 was a -15.1% loss (down 5.3%)

Current position: 38.5/33.5 for a max gain of 2.44%

XOM

Jan 85 Call

Jan 95 Put

Cost:$11.65/strangle

Max Possible loss on long: $1.65 (10%)

Loss 4.1% week 1, loss 2.49% (down 6.59% overall)(

Currently in the 85/90 for a max of a 2.44% gain

Well we learned that a gap in the markets Monday morning can crush the VXX trade. Again, if we had followed the rules and, instead of rolling on Friday, just closed, this would have been a profit. I am not re-entering any trade after the short gets hit -- you're betting against the trend for less money. The majority of other trades did exactly as they should. XOM is clearly the worst performer so far, as it has yet to have a positive week. I'll give it a full four weeks, but it will probably go off the list soon. I'm considering adding IWM.

If you have been in all of the trades the same time period I have, and have equal position sizing, then you should be up around 4%. After commissions, I'm currently up 3.96%, which isn't bad for three weeks, and has me on target for the 5% per month -- even with the big losers in there. Please note this does NOT include slippage (or loss) on the long positions -- I'll evaluate those at the end of the month (but I am watching them). Right now, I'm expecting to lose about half my gains due to losses in the longs.

[tjlocke99 18]

Chris,

Thanks.

This is kind of off topic, but my trade journal is becoming so big that I'm not consistently filling it out. I've actually resorted to just writing on paper. When I say big it means I have alot of columns in my spreadsheet now. For example on these trades, what columns/fields are you collecting data on?

Thanks!

[cwelsh 1,550]

I maintain two separate documents -- a trade LOG in excel. It has columns labeled "date" "description" "$" and comments

The description is just something like "Buy 10 65/65 TIF @ 3.00"

The comments section MUST be short. On earnings trades it'll say "BE $3.03, close by EOD Tues 11/28)." On my DD, it says "max return of 4.5% on $5,000.00" or something like that. (date and money should be self explanatory). The comment section always has my closing price, closing date, and things to watch for.

I then maintain a trade diary, which is a word file, where when trades go bad, or go well, or I start researching a new one, I take notes. It's quite extensive, and I update the index about every two months or so (word will prepare an index for you). I index by types of trades (e.g. earnings, DD, calendar, IC, RIC, etc), as well as symbols (e.g. AAPL).

I also have a notepad that I work out P/L graphs and sometimes backtesting as well. I have a big file for those, I date them, and then reference them in the trade journal. For instance, when I was backtesting the XOM DD, I used about 4 sheets of legal size paper. When done, I dated them, and then in my trade journal, typed the conclusions and noted that I had backtest on my notepad and the date (in the trade journal, I note that as "NBP 11/11/12" (NBP stands for "note book paper"). If I ever go back to my backtesting process, then I just find the entry in my trade journal, and go pull the results. That's pretty rare -- I'm normally only interested in the conclusions, which I transfer to the journal.

I update my trade log in excel as trades get filled -- I find if I don't then I find I get behind. I also have it up all day. (I highlight active earnings trades in yellow, DD in orange, cc in green, etc.). When a trade gets closed, I just take the highlighting off. This gives me a quick reference to look at regularly (as in multiple times a day).

I TRY to update my trade journal/diary daily. That doesn't really happen. I frequently have to go back and fill it in on the weekends -- but I do always at least make an entry if I need to put something in it (so for instance, today's entry might just be "11/26 - enter BT data from IWM" and this weekend I clean it up.

I file my notes from the pad about twice a month.

Yes this is a ton of work -- but trading is a job, and if you don't treat it that way, it's very hard to succeed.

[Kelly Park 10]

Chris:

A question about calculation on the DD trades. How are you calculating your max potential gain each week? comparing your credit to the original cost of the longs, or against an adjusted basis, factoring in all losses or gains to date? I have been tracking both and can't decide which is most useful.

[cwelsh 1,550]

I use the cost of the longs, but use my actual trading dollars, so commissions are included (so every one's rate of return should be slightly different).

For instance, if the long hedge cost $20.00, and I could sell short on the week for $1.00, that would be a max return theoretical return of 5%. Then if I closed the position for $0.50 (INCLUSIVE of commissions), then my actual return would be 2.5%.

I measure against the cost of the longs because that's what I'm out of pocket. Some people would continually adjust the "cost" of the longs down each week, (so using the above example in week 2, the cost of my long would be $19.50) -- I don't like that, and don't think it accurately reflects the cost and returns.

[Kelly Park 10]

I think you are right, Chris. I think of trades like calendars as single trades with a targeted total profit and the weekly sales bring the basis down. But these are intended as income trades, where the weekly income is the target. I know it is really two sides of the same coin, but I think of the two differently, and so it makes sense to me to adjust my basis in trades like calendars, but not on steady income trades.

[tjlocke99 18]

I maintain two separate documents -- a trade LOG in excel. It has columns labeled "date" "description" "$" and comments

The description is just something like "Buy 10 65/65 TIF @ 3.00"

The comments section MUST be short. On earnings trades it'll say "BE $3.03, close by EOD Tues 11/28)." On my DD, it says "max return of 4.5% on $5,000.00" or something like that. (date and money should be self explanatory). The comment section always has my closing price, closing date, and things to watch for.

I then maintain a trade diary, which is a word file, where when trades go bad, or go well, or I start researching a new one, I take notes. It's quite extensive, and I update the index about every two months or so (word will prepare an index for you). I index by types of trades (e.g. earnings, DD, calendar, IC, RIC, etc), as well as symbols (e.g. AAPL).

I also have a notepad that I work out P/L graphs and sometimes backtesting as well. I have a big file for those, I date them, and then reference them in the trade journal. For instance, when I was backtesting the XOM DD, I used about 4 sheets of legal size paper. When done, I dated them, and then in my trade journal, typed the conclusions and noted that I had backtest on my notepad and the date (in the trade journal, I note that as "NBP 11/11/12" (NBP stands for "note book paper"). If I ever go back to my backtesting process, then I just find the entry in my trade journal, and go pull the results. That's pretty rare -- I'm normally only interested in the conclusions, which I transfer to the journal.

I update my trade log in excel as trades get filled -- I find if I don't then I find I get behind. I also have it up all day. (I highlight active earnings trades in yellow, DD in orange, cc in green, etc.). When a trade gets closed, I just take the highlighting off. This gives me a quick reference to look at regularly (as in multiple times a day).

I TRY to update my trade journal/diary daily. That doesn't really happen. I frequently have to go back and fill it in on the weekends -- but I do always at least make an entry if I need to put something in it (so for instance, today's entry might just be "11/26 - enter BT data from IWM" and this weekend I clean it up.

I file my notes from the pad about twice a month.

Yes this is a ton of work -- but trading is a job, and if you don't treat it that way, it's very hard to succeed.

Fantastic info. Thanks Chris.

So you don't separate the costs out so you can automatically tabulate them? How are you calculating the totals then - are you doing it manually each time?

I think my mistakes are that I tried to break atomic piece of data up, so I have around 15 columns just for these trades.

Thanks!

[cwelsh 1,550]

I have a second entry for closing the trade, so it might look like this:

11/27/12 Open 20 50/50 XYZ Straddle @ 2.00 $4,040.95 Earnings Trade, Close 11/29, BE $2.04

11/29/12 Close 20 50/5 XYZ Straddle @2.12 $4199.05 Gain of $158.10, 3.9%

If I have other thoughts, I put it in the trade journal (or just post here -- I've gotten into the habit of archiving this site, and just including links in my trade journal).

[Rogers 263]

So far I am a fan of the strategy and learning a lot from managing it (which can be challenging). I am no longer trading XOM and am using more conservative shorts on VXX

[cwelsh 1,550]

So far I am a fan of the strategy and learning a lot from managing it (which can be challenging). I am no longer trading XOM and am using more conservative shorts on VXX

I'm looking for a good exit on XOM -- this week is actually behaving, but the returns aren't matching up to the risk, it does not look like a good long term candidate. I also am looking for an opportunity to roll out to further strikes (closer to the .80 delta) on the vxx -- I think we'll need to be at .80 delta or higher on ALL double diagonals, or the theta could just over run us.

[tjlocke99 18]

Chris,

I think Marco schooled me on this a few months ago, but I don't see the advantage of the using deep in the money approximately .80 and -.80 delta calls and puts as the long position.

What is the advantage of this versus going out about 2 months and purchasing a .20 delta long call and a -.20 delta long put?

Let me give you an example.

When I look at Goldman Sachs on 8/30/2012 I see:

GS @ 104.72

I know that GS reports on 10/16/2012, so I go long the Oct strangle which expires on 10/19/2012 giving me some vega protection.

I go long:

Oct 115 Call / Oct 95 PUT for $2.49

Oct 95 Call / Oct 115 Put for $22.50

They both have a negative theta of around $.07 a day at this point.

I then short that week the Sept1 12 110 Call and 100 Put for a credit of approx. $.60

Early in the week you are up, but GS makes a huge move that week. On 9/5 its at $109.94 (you are actually profitable on 9/5) and by 9/6 its at $113.54. This is an almost $9 and 8% move in less than a week.

Guess what. On 9/6 here is how you sit:

Oct 115 Call / Oct 95 PUT you paid $2.49 is worth approx. $140

Oct 95 Call / Oct 115 Put for $22.50 is worth approx. $137

Your short is worth -$299.

My point is how have you added protection by going DITM? All you are doing is adding capital outlay and thus decreasing your rate of return.

By the way, in this example, hopefully you exited on 9/5 when the stock made a 3+% move and you'd still be profitable and live to fight another week.

I think if anything I'd rather double the long OTM position (especially when its after an earnings date) to protect against a catastrophic move.

Any comments?

Thanks.

[trhanson 590]

You make some good points. I'm trying to think of a good reason to use DITM options, but I can't for the life of me figure one out.

Lets take GLD for an example. I just reopened this up on a PT.

I bought FEB 159C 175P for 18.65. That leads to a max possible loss on the long of 2.65

If I were to have bought the 159P and the 175C, I would be in about 2.62. Close enough to even. (again, that would be max possible loss on the long)

Continuing the strat, we sell the DEC 7 169C for .53 and the DEC 165 P for .49. Assuming your broker has smart enough software to know you can't get hit on both sides simultaneously, you will be required to put up $6 margin on the trade. This leads to an outlay of 8.62 or so making this trade have a possible return of 1.02 on 8.62 or 11.8% vs 1.02 on 18.65 or 5.47%

That just doesn't seem right to me, but I can't poke a hole in it... Chris, what are your thoughts?

[cwelsh 1,550]

I'm not 100% sure I understand your entry position, are you saying you bought both the 95 call AND the 115 call and the 95 put and the 115 put and went long on all of them? That makes no sense whatsoever -- its the identical P/L graph, except you slow your rate of return.

That aside, let me clarify a few things.

To sell short you have to have an equivalent long position -- I don't know of any broker that will just let you sell a naked strangle -- the long OTM position is for the purpose of permitting you to sell the short and generate returns. You could buy the stock, but that's more expensive. You could buy closer to ATM (let's say .60 deltas), but then theta creams you over time if you don't get a move.

We also have a FIRM rule in place that you DONT sell short during earnings, you just let that week ride, and ideally you have one of two situations either (a) a huge rise in IV, and you can sell the longs before earnings for an actual gain (or even BE), and reopen after the announcement or ( if you can't sell at a gain, then you hold through earnings -- if you get a big move, you profit, if you don't, well just go back to selling weekly against them.

If you are more conservative, then you don't have to sell against all of the longs. For instance, if I'm long 10 GS, I might only sell 5 against it weekly. That way if there's a big move, I'm largely covered -- but that has the added effect of reducing your rate of return by half, as well as making it harder to profit on small moves.

The PRIMARY purpose of going DITM on both sides is to avoid theta decay.

For instance, take stock XYZ trading at 100. If we buy the 120 call and 80 puts, with deltas about .40 , to sell the 95/105 against, and XYZ does what we want and STAYS in that range, each week we do it, we lose significant TV. Our maximum possible loss on the long position is actually 100%. All that has to happen is XYZ to stay between 80 and 120 and the week of expiration that long position is worth close to zero.

On the other hand, if we buy the 120 put and 80 call, with a delta about .80, the position will still have value -- no matter what. Since the sole purpose of the long is to give us something to sell against, if we can preserve that value, that's great.

It would be even better to go to .90 deltas or even .99, but at some point you can't generate enough return for the capital outlay. I've settled on .80 due to backtesting. Could .90 be better over time for a lower rate of return? Possibly, I don't know, I encourage anyone who wants to to look into it.

Hope that clears some things up.

[cwelsh 1,550]

You make some good points. I'm trying to think of a good reason to use DITM options, but I can't for the life of me figure one out.

Lets take GLD for an example. I just reopened this up on a PT.

I bought FEB 159C 175P for 18.65. That leads to a max possible loss on the long of 2.65

If I were to have bought the 159P and the 175C, I would be in about 2.62. Close enough to even. (again, that would be max possible loss on the long)

Continuing the strat, we sell the DEC 7 169C for .53 and the DEC 165 P for .49. Assuming your broker has smart enough software to know you can't get hit on both sides simultaneously, you will be required to put up $6 margin on the trade. This leads to an outlay of 8.62 or so making this trade have a possible return of 1.02 on 8.62 or 11.8% vs 1.02 on 18.65 or 5.47%

That just doesn't seem right to me, but I can't poke a hole in it... Chris, what are your thoughts?

I'll definitely look at this more tonight, but here are my initial thoughts:

1. For one week you seem correct, it appears to be a more optimal strategy

2. But what happens as the value of GLD slides around? For instance, 3 weeks from now, if GLD is at 170, your margin requirement is not going to be 6 -- its going to be much higher (as the spread is wider on one side of the trade). Your broker, even with smart software, is going to make you put up the amount to cover the wider of the two spreads.

3. I would think as expiration nears, and the price is still between 159 and 175, you would stand to lose more by being OTM than DITM, as the DITM has intrinsic value. However, I'm not sure of that and would have to backtest it.

4. I would want to make sure my broker's software would recognize a calendar/diagonal spread that was legged into each week. so I didnt get 2x on margin.

Who knows, maybe that ends up being a more optimal strategy, I'm certainly going to look at it and am not opposed to modifications.

[trhanson 590]

I agree that as gld slides, your margin requirement is going to go up, but in order to hit what we currently outlay at the beginning. For the GLD trade, i had to outlay 18.65 meaning on the other trade i could get hit for up to $16 in margin and be equivalent. GLD would need to be 175 or 159 of course. At that point in time, I'd probably just roll it.

I do know that going OTM is going to be a huge bookkeeping PITA as the % return is going to change every week depending on your margin requirements.

If I had a TOS account, i'd help with the backtesting, but as of right now i don't :-(

[Marco 223]

The PRIMARY purpose of going DITM on both sides is to avoid theta decay.

For instance, take stock XYZ trading at 100. If we buy the 120 call and 80 puts, with deltas about .40 , to sell the 95/105 against, and XYZ does what we want and STAYS in that range, each week we do it, we lose significant TV. Our maximum possible loss on the long position is actually 100%. All that has to happen is XYZ to stay between 80 and 120 and the week of expiration that long position is worth close to zero.

On the other hand, if we buy the 120 put and 80 call, with a delta about .80, the position will still have value -- no matter what. Since the sole purpose of the long is to give us something to sell against, if we can preserve that value, that's great.

It would be even better to go to .90 deltas or even .99, but at some point you can't generate enough return for the capital outlay. I've settled on .80 due to backtesting. Could .90 be better over time for a lower rate of return? Possibly, I don't know, I encourage anyone who wants to to look into it.

Hope that clears some things up.

doesn't make sense to me.

The long dated 80 C+120 Put will always have a minimum value of 40$ (American style options, ignoring rates and dividends) on top of that 40$ you pay the same time value that the 80P + 120C have. So the value of the ITM version is, is 40$ + the OOM version. If the stock stays between 80 and 120 the OOM version is worthless the ITM version is worth 40$ but both will have lost the same time decay over that time. The only difference is that the ITM version gives you the 40$ back that you paid upfront on top of the time value. So all you did is lend the market 40$ over the time of the option (and if its priced correctly the market will pay the market interest rate for that, however with rates near zero that's not that much at the moment and I can think of better ways to use my cash at the moment).

So you'll have the same $ P/L result buying the OOM strangle on the long end, I don't get why you go for the ITM version

[Kim 7,943]

The ITM options will protect you more in case of a big move - and I'm talking percentage wise. In dollar terms, the loss will be the same, but if you spend $50 on ITM options and $10 on OTM options and lose $5 with the large move, you lose 50% on OTM options but only 10% on ITM options. At the same time, the gain will be larger as well for OTM options - again, percentage wise, not dollar wise. It's the same as doing ITM strangle vs. OTM strangle that we discussed in the KR topic.

Taking GLD as an example - we are doing similar trades, I'm going with OTM options (164p/170c) and Chris with ITM options. IV decrease hurt both trades and the longs lost a lot, but my longs lost more percentage wise because I spent $5 on them and Chris spent $20. Both strangles lost roughly $2 in the last two weeks, but in my case it was 40% loss (which was roughly offset by the shorts) and in Chris case it was only 10% loss.

[Marco 223]

The ITM options will protect you more in case of a big move - and I'm talking percentage wise. In dollar terms, the loss will be the same, but if you spend $50 on ITM options and $10 on OTM options and lose $5 with the large move, you lose 50% on OTM options but only 10% on ITM options. At the same time, the gain will be larger as well for OTM options - again, percentage wise, not dollar wise. It's the same as doing ITM strangle vs. OTM strangle that we discussed in the KR topic.

Taking GLD as an example - we are doing similar trades, I'm going with OTM options (164p/170c) and Chris with ITM options. IV decrease hurt both trades and the longs lost a lot, but my longs lost more percentage wise because I spent $5 on them and Chris spent $20. Both strangles lost roughly $2 in the last two weeks, but in my case it was 40% loss (which was roughly offset by the shorts) and in Chris case it was only 10% loss.

well the % debate is misleading in my opinion. Just chose the P/L risk you want to have and invest accordingly.

keeping the no's from above example. Say the OOM version is 10$ and the ITM is 40$+10$ so 50$. No you can look it it in terms of premium you want to invest. Say you have 10000$. You can buy 2 lots of the 50$ version or 10 lots of the 10$ version. The risk is obviously much higher if you buy 10 lots. But I would look at in in terms of risk rather than premium. The max. time value loss in both (ITM and OOM version) is 10$. So if the max time value loss you want to have is 2000$ there is no need to go for the 50$ capital outlay to 'trick yourself' into a smaller position. Just buy a 2 lot of the OOM version, spend 2000$ rather than 10000$ and keep 8k in cash with the same risk profile. I don't get why you would rather tie your money up in an ITM option than having the cash sitting in your account (only reason would be the market pays you a lot better rate than your broker for the cash in the account, but as I said at the moment it will be both pretty much zero)

[Kim 7,943]

Marco, I don't disagree with you. We are talking about the same thing from different angle. All I'm saying is if want to invest the whole 10k, you will have higher risk and higher reward with OTM options - again, as percentage of invested capital, assuming you don't want to keep cash.

[Marco 223]

Marco, I don't disagree with you. We are talking about the same thing from different angle. All I'm saying is if want to invest the whole 10k, you will have higher risk and higher reward with OTM options - again, as percentage of invested capital, assuming you don't want to keep cash.

I'm pretty sure that you understand the difference and as me you seem to prefer cash on the account to money tied up in ITM options as I've never seen you trading ITM straddles, but from reaction of some other members I see that the fact that

ITM straddle = OOM straddle + bond/cash

seemed to surprise some and now that they know its the same they see little point in going with the ITM just as me.

btw:

if you want to lend money to the market without paying or receiving any time value here's the structure:

staying with XZY stock at 100 you buy the 80C, buy the 120 Put (aka as 'guts'/ITM strangle) and sell the 80P and sell the 120 Call (aka as the OOM strangle)

Depending on the maturity of the option and market interest rates you should pay a little or a lot less than 40$ for that and at maturity you get 40$ back. The difference to what you paid for it is your 'interest'. Spreads, slippage and commissions will most likely not make that a very competitive rate but these structures (aka box) are actually quoted and traded in the market as financing trades (people borrow or lend money through the exchange that way).

Edited November 29, 2012 by Marco

[tjlocke99 18]

I'm not 100% sure I understand your entry position, are you saying you bought both the 95 call AND the 115 call and the 95 put and the 115 put and went long on all of them? That makes no sense whatsoever -- its the identical P/L graph, except you slow your rate of return.

That aside, let me clarify a few things.

To sell short you have to have an equivalent long position -- I don't know of any broker that will just let you sell a naked strangle -- the long OTM position is for the purpose of permitting you to sell the short and generate returns. You could buy the stock, but that's more expensive. You could buy closer to ATM (let's say .60 deltas), but then theta creams you over time if you don't get a move.

We also have a FIRM rule in place that you DONT sell short during earnings, you just let that week ride, and ideally you have one of two situations either (a) a huge rise in IV, and you can sell the longs before earnings for an actual gain (or even BE), and reopen after the announcement or ( if you can't sell at a gain, then you hold through earnings -- if you get a big move, you profit, if you don't, well just go back to selling weekly against them.

If you are more conservative, then you don't have to sell against all of the longs. For instance, if I'm long 10 GS, I might only sell 5 against it weekly. That way if there's a big move, I'm largely covered -- but that has the added effect of reducing your rate of return by half, as well as making it harder to profit on small moves.

The PRIMARY purpose of going DITM on both sides is to avoid theta decay.

For instance, take stock XYZ trading at 100. If we buy the 120 call and 80 puts, with deltas about .40 , to sell the 95/105 against, and XYZ does what we want and STAYS in that range, each week we do it, we lose significant TV. Our maximum possible loss on the long position is actually 100%. All that has to happen is XYZ to stay between 80 and 120 and the week of expiration that long position is worth close to zero.

On the other hand, if we buy the 120 put and 80 call, with a delta about .80, the position will still have value -- no matter what. Since the sole purpose of the long is to give us something to sell against, if we can preserve that value, that's great.

It would be even better to go to .90 deltas or even .99, but at some point you can't generate enough return for the capital outlay. I've settled on .80 due to backtesting. Could .90 be better over time for a lower rate of return? Possibly, I don't know, I encourage anyone who wants to to look into it.

Hope that clears some things up.

Chris,

I never took the positions I referenced. I gave an example.

I'm not 100% sure I understand your entry position, are you saying you bought both the 95 call AND the 115 call and the 95 put and the 115 put and went long on all of them? That makes no sense whatsoever -- its the identical P/L graph, except you slow your rate of return.

No. I listed 2 potential long positions. The DITM strangle you have been purchasing vs and OTM strangle that I am mentioning in this post. The point is what the responses to this thread having been saying. The theta decay is the same on that ITM and OTM strangle. The ITM strangle is only raising your capital requirements.

I also didn't not reference a naked strangle in my example. I essentially listed a double diagonal only it is reversed because the far dated longs are actually further OTM than the shorts. Its like a modified IC. I have no idea what you call it.

[cwelsh 1,550]

I'm not sure either -- its not a reverse double diagonal -- I think its just a normal double diagonal with different longs (so an OTM DD), thats how I'm referring to it my notes.

And sorry for the misunderstanding, didn't realize you were listing two different possibilities, not doing both at the same time.

I just finished a monte carol on the GLD, assuming GLD stayed in a very tight range (+/- 2 pts), and the OTM worked MUCH better. I'm not sure if those results will hold if there are bigger swings due to the changing margin requirements. However, I think the increased number of contracts available on the OTM positions might offset that. i'll try to finish running simulations tonight and then backtest over the weekend.

I'm always up for optimizing strategies, and if OTM works better on an entire portfolio of these trades over the long haul, I'll certainly update it.

[cwelsh 1,550]

I have also rolled all my positions -- will probably post the updates tomorrow, about to have to run to a client meeting.

[Kim 7,943]

As you know, I started the GLD calendar 2 weeks ago. With GLD trading in the tight range and rapid theta of the weekly shorts, you would expect at least 15-20% gain by now. In reality, the trade is sitting on a small loss. The reason is dropping IV. IV of January options was 13.5% when I started the trade, it is below 12% now. Just to illustrate how critical vega is for those trades.

[cwelsh 1,550]

IV is getting quite low -- it makes the shorts almost not worth the risk on some instruments -- not at the August or April lows of 14 -- but we closed just above 15 on the VIX today.

[tjlocke99 18]

As you know, I started the GLD calendar 2 weeks ago. With GLD trading in the tight range and rapid theta of the weekly shorts, you would expect at least 15-20% gain by now. In reality, the trade is sitting on a small loss. The reason is dropping IV. IV of January options was 13.5% when I started the trade, it is below 12% now. Just to illustrate how critical vega is for those trades.

Great point Kim. How is it the earnings trades are doing so well lately then?

[tjlocke99 18]

IV is getting quite low -- it makes the shorts almost not worth the risk on some instruments -- not at the August or April lows of 14 -- but we closed just above 15 on the VIX today.

Is it a good time to enter into a longer term SPY short butterfly or something like that?

Also Chris, you could take the lower margin requirement and put that cash into a Reel Ken style high dividend blue chip long stock with one of his insurance schemes. The more I look at his scheme and my failed attempts to beat that ROR using options, I am thinking maybe his strategy is just the way to go on everything

I am also looking for a trade to cover a black swan (a black swan that is for a market that moves very quickly up or down though).

[cwelsh 1,550]

Great point Kim. How is it the earnings trades are doing so well lately then?

Because IV rose on them more than overall market volatility dropped -- (as should happen in theory). It also helped that some of those underlying stocks had a decent size move as well.

[Kim 7,943]

Right.. I was actually referring to IV of gold, the overall market IV is low but stable, not declining.

[cwelsh 1,550]

Update on last weeks closings and openings, again note these are INCLUSIVE of commission costs:

APA

Jan 72.5 Call

Jan 90 Put

Cost: $19.63

Max loss on long: $2.13 (10.85%)

Net returns: 1.8% week 1, -3.1% in week 2, 2.33% week 3, 1.81% week 4 (up 2.84% overall so far)

Current Position: 75/80, max 2.81%

GLD

Jan 159 Call

Jan 178 Put

Net Cost: $22.12

Maximum loss on the long position: $3.12 (14.1%)

Week 1 was a 3.7% gain, Week 2 was a 3.8% gain, 2.7% week 3, (up 10.2% overall)

Current position: 165/170 for a max of 3.48% gain

SNDK

Dec 38 Call

Dec 47 Put

Net Cost: $10.71

Max possible loss on long: $1.71 (15.9%)

Return: 2.98% week 1, 0.04% week 2, week 3 was a -2.5% loss, week 4 was a 6.8% gain, 4.75% week 5 (up 12.07% overall)

Current Position: 38/41 for a max 4.03% gain

VXX

Jan 30 Call

Jan 41 Put

Cost: $15.85/strangle (averaged down week 3)

Max Possible loss: $5.40 (32.9% -- because of this, we probably will close this one 2 weeks earlier than normal -- so mid-dec)

Net Return 4.78% in week 1, 3.82% week 2, week 3 was a 1.2% gain, week 4 was a -15.1% loss, 1.6% week 5 (down 3.7%)

Current position: 27.5/32.0 for a max gain of 2.44%

XOM

Jan 85 Call

Jan 95 Put

Cost:$11.65/strangle

Max Possible loss on long: $1.65 (10%)

Loss 4.1% week 1, loss 2.49% week 2, 1.00% gain week 3 (down 5.59% overall)

Currently in the 85/90 for a max of a 2.44% gain

Overall last week was spectacular -- every position gained, with GLD and SNDK carrying the banner for being the best positions.

I also spent most of the weekend re-running these trades using OTM positions instead of DITM and reached the following conclusions:

1. Assuming you remember to save the available cash for the max possible margin requirement, OTM is better just over 90% of the time.

2. It is only not better when the trade goes over a long period (over six weeks), you close it with two weeks or more left, IV has dropped, and your underlying has had only minor moves.

As someone else noted, it also makes measuring return rates a little more difficult, as your margin requirements change each week. That said, I will be moving to OTM positions the next cycle on the DD income strategy.

When am I rolling to the different positions -- well the first to occur of:

1. The natural closing point for the trades; OR

2. An increased in overall market volatility so I can get more premium for the long dated options.

[Hannes Kury 7]

Chris

You say:

@@@ When am I rolling to the different positions -- well the first to occur of:

@@@

@@@ 1. The natural closing point for the trades; OR

@@@ 2. An increased in overall market volatility so I can get more premium for the long dated options

To your point 2.: Wouldn't you want to buy the longs when volatility/premium is low?

[cwelsh 1,550]

Chris

You say:

@@@ When am I rolling to the different positions -- well the first to occur of:

@@@

@@@ 1. The natural closing point for the trades; OR

@@@ 2. An increased in overall market volatility so I can get more premium for the long dated options

To your point 2.: Wouldn't you want to buy the longs when volatility/premium is low?

Except I'm also selling the longs I have now, closer dated in time (e.g. higher theta) for a larger loss. If I was not in any position right now, you'd be correct. However, when I entered these originally, I planned to hold to 2 weeks or so before expiration to maximize gains -- that hasn't changed. At current volatility levels, I have the chance of maximizing profit by holding and continuing to sell as I am.

[Kelly Park 10]

Chris:

I've kinda lost track of the deltas we are targeting for our weekly shorts, since it varies by each underlying.

[tjlocke99 18]

Update on last weeks closings and openings, again note these are INCLUSIVE of commission costs:

APA

Jan 72.5 Call

Jan 90 Put

Cost: $19.63

Max loss on long: $2.13 (10.85%)

Net returns: 1.8% week 1, -3.1% in week 2, 2.33% week 3, 1.81% week 4 (up 2.84% overall so far)

Current Position: 75/80, max 2.81%

GLD

Jan 159 Call

Jan 178 Put

Net Cost: $22.12

Maximum loss on the long position: $3.12 (14.1%)

Week 1 was a 3.7% gain, Week 2 was a 3.8% gain, 2.7% week 3, (up 10.2% overall)

Current position: 165/170 for a max of 3.48% gain

SNDK

Dec 38 Call

Dec 47 Put

Net Cost: $10.71

Max possible loss on long: $1.71 (15.9%)

Return: 2.98% week 1, 0.04% week 2, week 3 was a -2.5% loss, week 4 was a 6.8% gain, 4.75% week 5 (up 12.07% overall)

Current Position: 38/41 for a max 4.03% gain

VXX

Jan 30 Call

Jan 41 Put

Cost: $15.85/strangle (averaged down week 3)

Max Possible loss: $5.40 (32.9% -- because of this, we probably will close this one 2 weeks earlier than normal -- so mid-dec)

Net Return 4.78% in week 1, 3.82% week 2, week 3 was a 1.2% gain, week 4 was a -15.1% loss, 1.6% week 5 (down 3.7%)

Current position: 27.5/32.0 for a max gain of 2.44%

XOM

Jan 85 Call

Jan 95 Put

Cost:$11.65/strangle

Max Possible loss on long: $1.65 (10%)

Loss 4.1% week 1, loss 2.49% week 2, 1.00% gain week 3 (down 5.59% overall)

Currently in the 85/90 for a max of a 2.44% gain

Overall last week was spectacular -- every position gained, with GLD and SNDK carrying the banner for being the best positions.

I also spent most of the weekend re-running these trades using OTM positions instead of DITM and reached the following conclusions:

1. Assuming you remember to save the available cash for the max possible margin requirement, OTM is better just over 90% of the time.

2. It is only not better when the trade goes over a long period (over six weeks), you close it with two weeks or more left, IV has dropped, and your underlying has had only minor moves.

As someone else noted, it also makes measuring return rates a little more difficult, as your margin requirements change each week. That said, I will be moving to OTM positions the next cycle on the DD income strategy.

When am I rolling to the different positions -- well the first to occur of:

1. The natural closing point for the trades; OR

2. An increased in overall market volatility so I can get more premium for the long dated options.

Thanks Chris.

Chris, I also think the slippage is not as bad in absolute slippage (obviously not as the percentage of the overall trade). This is NOT a minor point. I have tried to close an XOM and SNDK DITM strangle for a few days and can't get executed even .10 off the mid!

Is there any possible trade that could be added to this to protect against a 2+ SD move in the underlying? I know it'll cut into the P&L, but I personally don't have alot of gamma exposure.

[cwelsh 1,550]

The odds of a 2+SD move in the underlying, not around earnings or major news, on an independent basis is pretty small. I would be worried more about a large market move that moves all of our positions. In that case an SPY strangle might be a good idea several months out. Don't know how expensive that would be though.

And try legging out -- I had no problems getting out when I executed each side independently (actually got above mid). Closing out long dated strangles, ICs, or any multileg trade that's either DOTM or DITM can be difficult because it can be hard finding someone who wants to cover that exact trade.

[Kelly Park 10]

Chris:

Seems like the DD discussions have gone a bit cold lately. I'm still in the VXX and GLD trades and following a couple of different approaches. To catch up, I think we were discussing using OTM longs instead of ITM. Have you reached any conclusions about best deltas? I have been fiddling with this and by my reasoning (possibly faulty) it actually looks like ATM works best. Here is my reasoning:

It seems to me that the purpose of this trade is to sell time value, choosing short deltas that balance credit received with the likelihood of getting hit. So, choosing deltas that will only get hit, what, maybe 1/2 to 2/3 of the time? Even if we get hit 3/4 of the time on one leg, but set stop losses so we retain SOME credit for the week (and we get whipsawed for losses very infrequently) then it works out. I have lost track of what deltas should be working best, since they change with each underlying. A recap would be helpful, if someone could provide it.

BUT, we don't want to risk of holding naked shorts, so we buy longs. The trick here is to find the longs that are the cheapest in the long run (i.e. least cost including both initial investment AND theta decay). With DITM, we don't have much theta, but the upfront cost is high, so lower ROI overall. With DOTM, basically same theta, and the lower initial cost is offset dollar for dollar by margin requirements. I think I would rather have the margin requirement, as I could put that money in something safe but still mildly profitable and increase my overall return a bit.

However, I have been fiddling with the numbers (so far, only on GLD) and it appears to me that ATM works best. If you plot the theta decay from week to week, out about 3 months, it doesn't vary much for OTM, ATM, ITM, DITM or DOTM as long as you sell them 3 weeks before expiration. With DOTM and DITM, you might be able to go another couple of weeks closer. (For GLD, the weekly theta decay averages about .17/week ATM, about .19 DITM or DOTM and .21 OTM or ITM) So if theta losses are similar, then it comes down to total initial cost, which is lowest ATM. I haven't tried this with real money yet, but it appears that the DD trade has the highest ROI with ATM longs.

Then it is just a matter of choosing the best shorts.

Chris, please shoot holes in this reasoning before I am tempted to think I have learned something meaningful. And let's continue the discussion, as I think this is a very viable trade option.