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Diagonal Spreads - Discussion, Q&A, etc
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Author Diagonal Spreads - Discussion, Q&A, etc
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Post: #16   PostPosted: Sat Nov 30, 2013 6:45 pm    Post subject: Reply with quote

ST,

Can't thank enough for material shared through this thread.

Please keep it up.

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SwingTrader
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Post: #17   PostPosted: Sat Nov 30, 2013 8:34 pm    Post subject: Reply with quote

Thanks everybody.

@rk_a2003 said it right - there is no free lunch. One still needs to predict or get in line with the trend. One also needs to keep an eye on volatility as it can affect the profitability significantly (but it will affect only the degree of profit). But the important thing about diagonals is that they don't take a big bite out of our funds if we are wrong about the trend.

I use diagonals a lot because I use a large position size and I just can't afford to lose a large chunk if I go wrong. Diagonals let us stay in the game long enough to profit.

The next lesson is going to be another eye opener. What happens to these positions in a sideways move?

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Post: #18   PostPosted: Sat Nov 30, 2013 9:34 pm    Post subject: Reply with quote

3. Long Option vs Vertical Spread vs Diagonal Spread (Going nowhere / sideways range trades)

Let us now look at the performance of these three strategies in a sideways move.

I am deliberately picking the range from 10th Sep 2013 to 26th Sep (expiry day) because this was a sideways range overall and would help us in analyzing the performance of these strategies in a sideways move.

Long Option (LONG NF SEP13 5800 CALL)



Long option is all over the place during the sideways move.

Vertical Spread (LONG NF SEP13 5800 CALL + SHORT NF SEP13 6000 CALL)



Vertical makes sure we don't lose much in this sideways move but we still eventually face a loss, though it is not much.

Diagonal Spread (LONG NF OCT13 5800 CALL + SHORT NF SEP13 6000 CALL)




Diagonal shines brightly here. It does not have a negative day through out the trade.

Why does the diagonal work so well in the above trade whereas the vertical does not?

1. The long option in the diagonal is the next month option which has lot more time value due to more number of days left to expire. So even at SEP expiry it will still have lot of time value left. This also means the long option in a diagonal loses value due to time decay at a much slower rate than the long option in a vertical (long option in a vertical expires along with the short option).

2. The short option in a diagonal loses time value at a much faster rate when compared to its long option. This is because the short option is going to expire lot sooner than the long option. In addition to this, the short option is also out-of-the-money which makes it lose value faster than the in-the-money long option.

Due to the above two points we have lots of good things going for the diagonal:

1. The diagonal will lose less if the trade goes against us

2. The diagonal will profit a bit more than vertical if the trade goes in our expected direction

3. The diagonal will profit if price just goes sideways (but stays atleast a bit above the long option strike price)

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Post: #19   PostPosted: Sun Dec 01, 2013 10:00 am    Post subject: Reply with quote

"I use diagonals a lot because I use a large position size and I just can't afford to lose a large chunk if I go wrong. Diagonals let us stay in the game long enough to profit."

This should be the guiding philosophy for retail traders. Staying patiently at crease safeguarding your wicket... accumulate run by run... and at the end of the day register your century and rise your bat.

There is no point in hitting 2 consecutive sixes and getting out for the next ball. Life is not a 20-20; It's a Test match even more longer than that.
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Post: #20   PostPosted: Mon Dec 02, 2013 8:04 pm    Post subject: Reply with quote

Example time....

Those of you who have checked my market sentiment thread might remember that I had taken a bearish put spread trade on 12th Nov to test a bearish OTM PCR signal. I closed this trade for a tiny profit of around 4.5%. Below is the P/L summary of the trade compared with a hypothetical diagonal that could have been used instead.

I am using EOD prices for both as I had initiated the vertical spread around 3:15 PM on 12th Nov and EOD prices are almost the same.

Vertical Spread (LONG NF NOV13 6200 PUT + SHORT NF NOV13 6000 PUT)

My actual spread : 6200 PUT @ 162.35, 6000 PUT @ 61.60



Diagonal Spread (LONG DEC13 6200 PUT + SHORT NF NOV13 6000 PUT)



The diagonal would have been better. I could have closed the trade for around 10% profit instead of 4-5%. The above stats indicate P/L until 28th Nov expiry day. I actually closed the trade on 27th just before market close.

The diagonal spread pricing may not be good to initiate a trade just two weeks before expiry. I try and get a 35% hedge for my long option (short option price divided by long option price in %). But at times I take the trade if % hedge is 30% or more. 30% is surely the lowest I take. If this hedge % rule is followed, one can stay out of big trouble.

30% hedge is sometimes difficult for CALL spread but quite easy for PUT spreads as OTM puts usually are expensively priced as they are used to hedge portfolios and are thus more in demand.

One more important thing to remember. The diagonal's greatest risk will be within 4-5 days of trade entry. This is because time decay would not have started eroding the short option premium by that time. After 4-5 days of entry, the trade starts to strongly swing in our favor (I mean in terms of risk. risk starts to go down 4-5 days after trade entry).

I will post more detailed diagonal trade entry criteria/guidelines later.

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Post: #21   PostPosted: Mon Dec 02, 2013 8:15 pm    Post subject: Reply with quote

Thanks & waiting for more.
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Post: #22   PostPosted: Mon Dec 02, 2013 8:20 pm    Post subject: Reply with quote

st sir in your example of losing trade for shorting put, u have selected one strike price out of the money put option but your example in profitable trade u selected two strike price out of the put option(5500pe) if any reasons please explain
SwingTrader wrote:
2. Long Option vs Vertical Spread vs Diagonal Spread (Profitable Trades)
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Post: #23   PostPosted: Mon Dec 02, 2013 9:38 pm    Post subject: Reply with quote

sairanga19 wrote:
st sir in your example of losing trade for shorting put, u have selected one strike price out of the money put option but your example in profitable trade u selected two strike price out of the put option(5500pe) if any reasons please explain


This will get more and more clear as I post examples. In short here is the process for strikes selection:

I start with nearest OTM long and further two strikes OTM short looking for 30-35% hedge. For the nearest OTM long + OTM short if I don't get 30-35% hedge then I go nearer or in the money for the long (and short) and check the hedge % again. Once I find 30-35% hedge I take those two strikes. For 2nd Aug trade the hedge % for 5700-5500 trade was approx. 34% (54/158). I start with OTM diagonal as it gives higher profit but I still want 30-35% minimum hedge % so I check that.

Here is what would have happened if I had selected a further in-the-money diagonal for the 02.08.2013 put diagonal:

Diagonal Spread (NF SEP13 5800 PUT + NF AUG13 5600 PUT)



It worked out perfectly fine too but degree of profit was less as it was more in-the-money but the degree of protection was also greater. The P/L drawdown while in the trade was less than the ATM diagonal I had used earlier.

In short, The most OTM (or ATM/ITM in that order) diagonal that satisfies the minimum required hedge condition is the one I choose.

I hope this clears your doubt. I will post more ITM, ATM, OTM diagonal examples for same trades so the degree of profit/loss becomes more clear.

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sairanga19
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Post: #24   PostPosted: Tue Dec 03, 2013 9:59 am    Post subject: Reply with quote

YES SIR thanks very much
SwingTrader wrote:
sairanga19 wrote:
st sir in your example of losing trade for shorting put, u have selected one strike price out of the money put option but your example in profitable trade u selected two strike price out of the put option(5500pe) if any reasons please explain


This will get more and more clear as I post examples. In short here is the process for strikes selection:

I start with nearest OTM long and further two strikes OTM short looking for 30-35% hedge. For the nearest OTM long + OTM short if I don't get 30-35% hedge then I go nearer or in the money for the long (and short) and check the hedge % again. Once I find 30-35% hedge I take those two strikes. For 2nd Aug trade the hedge % for 5700-5500 trade was approx. 34% (54/158). I start with OTM diagonal as it gives higher profit but I still want 30-35% minimum hedge % so I check that.

Here is what would have happened if I had selected a further in-the-money diagonal for the 02.08.2013 put diagonal:

Diagonal Spread (NF SEP13 5800 PUT + NF AUG13 5600 PUT)



It worked out perfectly fine too but degree of profit was less as it was more in-the-money but the degree of protection was also greater. The P/L drawdown while in the trade was less than the ATM diagonal I had used earlier.

In short, The most OTM (or ATM/ITM in that order) diagonal that satisfies the minimum required hedge condition is the one I choose.

I hope this clears your doubt. I will post more ITM, ATM, OTM diagonal examples for same trades so the degree of profit/loss becomes more clear.
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Post: #25   PostPosted: Wed Dec 04, 2013 9:38 pm    Post subject: Reply with quote

ST,
Is taking vertical spreads suitable for trading short term swings in NF i.e. for 2 to 5 trading days and 50 to 200 points?
Thanks,
vvsp.
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Post: #26   PostPosted: Wed Dec 04, 2013 9:47 pm    Post subject: Reply with quote

vvsp wrote:
ST,
Is taking vertical spreads suitable for trading short term swings in NF i.e. for 2 to 5 trading days and 50 to 200 points?
Thanks,
vvsp.


Yes, you can but your timing has to be good. If your timing is really good then you can use slightly OTM verticals, if timing is not good then best to stick to ITM verticals for less risk.

But do understand that for 50-200 pts move in NF, verticals will give only a fraction of it. Basically, if your vertical delta is 30 then you will get approx 30% of the NF move if the trade goes your way.

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Post: #27   PostPosted: Wed Dec 04, 2013 9:54 pm    Post subject: Reply with quote

SwingTrader wrote:
vvsp wrote:
ST,
Is taking vertical spreads suitable for trading short term swings in NF i.e. for 2 to 5 trading days and 50 to 200 points?
Thanks,
vvsp.


Yes, you can but your timing has to be good. If your timing is really good then you can use slightly OTM verticals, if timing is not good then best to stick to ITM verticals for less risk.

But do understand that for 50-200 pts move in NF, verticals will give only a fraction of it. Basically, if your vertical delta is 30 then you will get approx 30% of the NF move if the trade goes your way.

Thank you.
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Post: #28   PostPosted: Fri Dec 06, 2013 11:13 am    Post subject: Reply with quote

4. Effect of volatility trend on diagonals

Diagonals have higher vega (the option greek that gives an indication of how much an option can move if volatility changes) due to far month long option we hold. Far month options are affected more due to changes in volatility than the near month ones. So if volatility decreases significantly when we are holding a diagonal then our losing trades could lose significantly more than they would have lost if volatility had stayed stable. For winning trades the degree of profit will get reduced.

Assume we just closed a losing diagonal trade and on analyzing we found that volatility was stable throughout the trade. If the loss on the trade was around 10%, we could have lost around 14-18% if volatility had crashed. A slow decline of volatility would not affect that much but a volatility crash would affect it significantly.

For a profitable trade on which we had profited around 20% (as an example) if volatility was stable throughout the trade, we would probably profit only around 12-14% if volatility had crashed.

Volatility exploding would benefit both losing & winning trades. Losing trades would lose less and winning trades would win faster and more. We have seen examples of Aug 2013 trades earlier. Do look at INDIXVIX chart for Aug 2013, volatility just exploded like anything. The put diagonal returned about 10-12% more in this case.

The important lesson here is that one must swiftly decide what to do with losing trades. If volatility has started to increase fast and price does not seem to go in favor of our trade then it would be best to close the trade (if one is already losing significantly on the trade). Monitoring volatility is more necessary for losing trades because it can affect the degree of loss. For winning trades this is less important because if we get the direction right then it will override any implosion of volatility and we might only get a bit lesser profit. We will discuss more on this in the last lesson on managing diagonal positions.

No examples here. This is something to be kept in mind when you monitor any diagonals you are holding. For examples of volatility explosions look at INDIAVIX in AUG 2013 and for volatility implosion (decrease) look at SEP-OCT 2013.

In the next lesson we will look at rules for initiating diagonals.

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Post: #29   PostPosted: Fri Dec 06, 2013 6:22 pm    Post subject: Reply with quote

5. Trading Diagonals - Guidelines

Timing

When you are trading diagonals, you are taking a directional bet. This means timing is going to be important. There is some hedge built into the trade as a result of the short option and slower time decay of long option but rough timing is still critical because this is a directional trade. The idea is to try and see that price stays above the long option by the time you decide to exit the trade (we may even profit if price goes slightly against us). There are number of ways to decide on the direction, it does not matter which one you choose. Just make sure you stay consistent and use a single method to pick the direction. A single method is necessary for the probabilities to start working in your favor. I will suggest a method later when I post examples but it is best you choose a method of your liking.

Selecting Option Strikes

This is critical. There are various ways to select strikes like finding mispriced options and using volatility skew but I will not go into either of these methods as it will get fairly complicated. Also, since we are taking a directional trade we will profit even if both mispricing & skew are absent as long as eventually our directional estimate is roughly right.

I suggest the % hedge method for selecting strikes that I have mentioned previously. I have arrived at this method through lot of trial and error. Follow these steps for strikes selection:

*** We will talk only about NF here as no other scrip has liquidity good enough to trade diagonals in the Indian market ***

1. For long option take strike from the next/far month. Select the strike that is at-the-money (ATM) or slightly out-of-the-money (OTM). NOTE: ATM or OTM is with respect to current month futures price and not the next month (even though the strikes are being selected from the next month).

2. For short option take strike from the current/near month that is two strikes OTM from the long strike selected. Long and short options two strikes apart is optinum for NF. One strike apart and the profit will start to dip after price crosses the short strike which can be a major problem in managing the trade. More than two strikes part means you will not be able to get the optimum hedge % required (see the next point about this).

3. Compute the hedge % using the formula below:

Hedge % = (Price of short call / Price of the long call ) * 100

4. If the hedge % is above 30% this strike combination can be selected. If the hedge % is less than 30%, start the process again from #1 by going for more nearer ATM or ITM option for long and then repeat the steps and recompute the hedge %. Most of the time we end up with ITM long and OTM short which is usually the opinum combination unless one is initiating the trade close to expiry when the position has to be more ITM to provide enough protection.

5. Once you have a strike combination with hedge % greater than 30%, it can be used to enter the trade.

Time to expiry

Try and have atleast 3 weeks to go to short option expiry. The more nearer to expiry a diagonal is initiated the more ITM it should be to have adequate protection. This is more or less automatic if one sticks to the 30% hedge guideline. Even if one tries, one cannot initiate an OTM diagonal near to expiry that still provides 30% hedge, one has to go for ITM diagonal as one nears expiry. So if this guideline is followed one usually is able to stay out of serious trouble.

Important Points to note:

1. The more nearer or ITM the long & short option strikes are the more protection you get for your position BUT lesser the profit potential.

2. The more far away from ATM the strikes are the less protection you get for your position BUT greater the profit potential.

3. I have arrived at 30% hedge after lot of trial and error. It provides an optimum balance of risk vs reward.

4. For PUT diagonals one can easily get much more than 30% hedge % as puts are usually expensively priced. For CALL diagonals one has to go more near/ITM to get the 30% hedge %.

5. Do not compromise on the hedge % unless you know what you are doing and are ready to deal with the position risk.

6. First few days after initiating the diagonal are very tricky IF price moves fast against you. Before you enter the trade, decide a % stop loss or NF/NS based stop loss. Once 5-7 days pass, the position gets better as time decay sets in for the short option.

7. Also, decide on a profit exit before you enter the trade.

8. In general diagonals will benefit if volatility explodes when the trade is on and will suffer if volatility implodes suddenly. A gradual increase or decrease of volatility will not have much of an impact on the position.

I guess I have managed to put all guidelines I can think of about initiating a diagonal. If I recollect any more, I will edit this post and add those here. The next post will be about managing the diagonal trade - targets, stop loss, when to exit etc etc. After that post I will start posting examples.

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Last edited by SwingTrader on Sat Dec 07, 2013 9:42 am; edited 1 time in total
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Post: #30   PostPosted: Fri Dec 06, 2013 9:58 pm    Post subject: Reply with quote

Thank you so much ST.I felt like you are guiding me in my trade. Laughing

Are there any guide lines for setting profit target or is it purely subjective??
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