In part two of our series, we’re going to look at how we can adjust our original strategy (the Put Diagonal) to take advantage of a fairly large push lower by the SPY’s.
We started our strategy on Friday, March 14 with a Put Diagonal (see original article) and by Monday morning, things were looking pretty ugly for the markets as emergency moves had to be taken over the weekend by the Federal Reserve to deal with Bear Sterns. As a result, the Asian markets had sold off quite hard on Sunday and by Monday morning the index futures in the U.S. were pointing to a big down day initially.
When the markets opened, the SPY gapped down, immediately rallied off the low, rolled over and headed back down to test the day’s low once again (See chart 30 minute chart below). As the market pushed to the days' low for the second time, I modeled out morphing the original Put Diagonal, into Double Calendars - to shift the entire strategy lower in case the lows were taken out. At that time I was just testing the waters to see what the shift would look like. If the SPY took out the low and continued to press to the 124 area (our long strike), I would have begun the morphing process.
The model below uses actual market prices and volatility's at the time it was created. With the sell off that day, the VIX was spiking up. I had a feeling much of the volatility spike was being forced on the front month options. I wanted to see if we did indeed have a volatility skew between the front and back month when morphing to double calendars. Sure enough we did – about a 4% skew, which was making the initial adjustment that much more attractive.
The Mechanics of a Put Diagonal Morph Into Double Calendars
Our original Put Diagonal starts off by Shorting the April 129 puts and Buying the June 124 puts. To morph it into double calendars, we simply reverse the process by adding Short April 124 puts and Long June 129 Puts. This shifts the entire profit zone lower, as the diagrams below illustrate.
In the comparison diagram above, you can see that this strategy shift moves our initial lower breakeven down to the 118 area from 123, giving us almost another 7% protection from the 126.55 area. It also greatly expands our profit potential at these lower prices by a wide margin and still gives us an upper breakeven about 8% above current prices (around the 136 area).
This is the initial defensive chess move. If the market structure really wanted to play at lower levels, we could add another calendar series below the 124 Calendars – around the 120 level. This will give us a breakeven around the the 114 area.
One of the big caveats of these adjustments is how much time has elapsed since the original strategy was put on. As we get closer to the April expiry, adjustments may have less effect as the premium is eroding. On the other hand, if enough time has gone by, there is also a good chance that profits have built up in the original strategy also.
This article should serve as an overview only. There are many factors that should be considered when making adjustments on original strategies. My purpose today is to hopefully educate and open your mind to the potential and flexibility of option strategies. And of course - good modeling software helps.
In part three of this series, we're going to look at how we can increase our profits and range potential should the market want to suddenly push higher.
Thanks and continued success with your trading!
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