This more advanced article on Double Diagonals is a follow-up to an article covering the basics of Double Diagonals from last year.
In order to properly explain the topic of Advanced Double Diagonals, an example of a live trade will be utilized. The trade was entered on Thursday 4/19/2012 while the XEO (S&P 100 cash-settled index) was trading at $629.59 with the following goals; the first goal was to pay off some of the initial debit of placing the Double Diagonal with the sale of weekly options, and the second goal was to end up with some profit. Specifically, the goal was to accumulate at least ten percent on the trade. For the sake of simplicity, this article will present a single spread. Figure 1 lists the long legs which were bought on the regular monthly options.
|BTO + 1 May 650 call||1.90|
|BTO + 1 May 615 put||7.70|
As stated above, the XEO at the time (Thursday 4/19/2012) was trading at $629.59 and the purchase of both of the May legs were out-of-the-money (OTM), yet due to so many weeks out, the premium was expensive. None of the premium value of the May 615 put or May 650 call was due to the intrinsic value. Knowing this fact, one might wonder then, why would those OTM legs be purchased at all, at such a high cost of nearly $1,000 dollars. To be exact $960 was paid only for fluff, or time. The trading plan was aimed at selling weekly options against the long May (3rd week expiry) options. So how many weeks of the weekly options could be sold against the long options?
|2||May week B||5/11/2012|
|3||May week A||5/4/2012|
|4||April week D||4/27/2012|
Figure 2 above points out that a total of four weeks could be sold, however, let us regurgitate the trading plan’s goals: buy the long OTM legs with the intention of selling the diagonal weekly OTM options for several weeks, reducing the initial debit and waiting for the opportunity to close the Double Diagonal for a profit. Once again the goal was to get out as soon as these two objectives could be met.
The very first week, the following legs were sold: STO -1 Apr week D 645 call @ 0.50, and STO – 1 Apr week D 620 put @ 3.45 bringing in an aggregate of (3.45 + 0.50) 3.95 which reduced the cost of the entry (9.60 – 3.95) to 5.75 or in other words, the cost of the initial Double Diagonal was lowered down to only $575. As soon as these short legs were filled the orders to close them for a nickel were entered and a week later, Friday 4/27/2012 these were filled. The XEO was trading at $638, which was still in between the sold 645 call and 620 put. As soon as these were filled, the new cycle (May week A) of the 645c/620p was sold. The aggregate premium received from these two was $2.10 which brought the debit down from 5.75 (we added 0.10 for buying back the two Apr week D legs for a nickel) to 3.65. These May week A sold legs also expired worthless because the XEO closed on 5/4/2012 at $622.73, again within the 645/620 spread. Yet due to a significant drop near the sold 620 put, the opportunity presented itself to close the long May legs for a profit and terminate the trade. Instead of selling the May week B options, the decision was made to exit. Selling the same 620 put and 645 call once again would have be risky.
On Monday, 5/7/2012, instead of dragging on the trade for another couple of weeks, while the XEO was trading dangerously near the 620 level, the decision was made to close the long May 615 put, (the filled price was 4.05) as well as the long May 650 call. The long call, while it still had some value, received back only 0.20 which together with the premium from the sale of the May 615 put equals 4.25
Once that amount of 4.25 gets subtracted from the left over debit of 3.65 we end up with the profit of 0.60, which is exactly what was originally aimed at when the trade was entered on Thursday 4/19/2012. This is at least a ten percent rate of return on the initial investment of $565. (0.60/5.65 = 10.6% rate of return).
In conclusion, test your trading theories with a single contract first and stick to your trading plan rigidly, regularly, & religiously. Good luck and may all your option trades be green.