I have been comparing and contrasting verticals vs diagonals, and I don't really see a major advantage of diagonals over verticals. For example, I was looking at the (ES is the underlying)JAN P675/P500. At the time of the look, the credit was for 5.15. The Greeks for the P765: IV=67.12; delta=.0802; gamma=.0008; vega=.4446; theta=-.4819. The Greeks for the P500: IV=88.45; delta=.0127; gamma=.0001; vega=.0823; theta=-.0984. I also looked at the JAN P675/FEB P375. The credit was for 5.05. The Greeks for the FEB P375: IV=87.96; delta=.0062; gamma=.0001; vega=.0786; theta=-.0436. Correct me if I'm wrong, but the advantages I see with the diagonal are: 1) The FEB long Put delta, vega and theta are lower than the Jan long put. This says to me that the FEB long will not lose its value as quickly as the JAN long, and if the underlying does approach the short strike, the FEB Put may actually gain some value. 2) Volatility appears to be a wash between the two longs, and I am not sure of the significance. 3) Once the front-month expires OTM, and a near-month option can be sold, converting the former diagonal to a vertical spread. Looks like I save commissions here. Other things I have read about diagonals: They benefit if IV rises, and they benefit when the near-month IV is higher than the IV in the deferred month ( I assume that one would compare same strikes in different months to see this). They lose if IV collapses ( I don't see this--usually when IV collapses, the market moves up and a profit is seen (the credit received is the minimum profit), or they lose if the market sharply trends downward--which makes no sense if you want IV to increase..unless you want a steady increase of IV--right). I appreciate your comments.
Let me begin by telling you I never use ES. I've traded options on equities and equity indexes for more than 30 years. I don't see why there should be major differences between the options of futures and options on equities. If there are, then my statements may be misleading. 1) IV does not collapse during a market free-fall, nor will it ever do so. But, when market volatility declines - and it will someday - then IV follows that decline. And that's true regardless of whether the market rises or falls - as long as the decline is nothing resembling a 'free-fall.' 2) If you want to see the effects of vega on the expiration date, it's necessary to choose strikes that are relatively near each other. Once you select a January Put to sell, your choice is going to be whether to buy a Jan or Feb put as a hedge. If I'm selling a Jan 700 SPX put, My choice would be between buying a Jan 650 put and a Feb 625 P. That suits <i>my</i> comfort zone. To me the Jan 675/Feb375 is not really a spread because the strikes are so far apart. I am NOT telling you what to trade, but if you want to compare the greeks, then the Jan and Feb options you are comparing should not be the 500 and the 375. 3) When you write about things you have 'seen' - may I ask how long you have been looking at these types of option spreads? The markets of recent times are extraordinary by any standards. I'm sure you know that. 4) Yes, no matter how far the underlying moves higher, the longer-term put option should retain some value as the near-term option expires worthless. But, when IV is relatively high as it is right now, you must find a significant separation between the strike prices to buy the longer-term for approximately the same price as the near-term. To me, that makes risk unacceptable. If the market collapses, you would gain something by owning the longer-term option, but because the difference between the strike prices is so large, the maximum loss is very high. If you choose a Jan vs feb with similar strikes, then you are going to pay more cash for that Feb - and a big move to the upside can reduce that Feb to a level that is much lower than the 'extra' you pay to buy Feb vs buying Jan. That's what I mean by a large up move costs when you pay extra for vega. But you don't want to pay extra for vega. You would rather buy a further OTM option. There's a combination of factors here and you are looking for a strategy that suits your comfort zone. If you want to own a diagonal spread with strikes that are far apart and take that downside risk, then that's fine for you. I will not do that. I only buy diagonal spreads when IV is cheap and I don't have to pay extra to get those longer-term options. 5) " DO YOU AGREE THAT IF THE NEAR-MONTH IV IS HIGHER THAN THE FAR-MONTH IV THAT THE DIAGONAL IS A BETTER TRADE?" Absolutely not. the near-term IV is almost always going to be higher than any longer-term option. It is not the IV that matters. It's the dollars. It's the cost. If IV collapses and IV drops, the longer-term option gets crushed. In your scenario in which you pay an equal price for either option, that is NO problem. For me, and narrower put speads, that would be a big problem. IMHO, that 'higher IV' is a trap that grabs many diagonal traders. Sure doing this in Sep would have been good - but only to the extent that your strikes were not that far apart. If you have a put spread in which both legs move 200 points ITM, it's not going to help you to own a very deep ITM put option because the benefit of owning extra vega disappears. 6) I have not done any diagonal spreads for quite awhile now. I would never have predicted this surge in IV, so would not have gone long vega. I did try to own extra gamma - but not vega. I am only trading vertical spreads now - specifically iron condors and not just put spreads. But diagonals are out of the question for me - at this time. Mark
Thank you for the detailed explanation; it was extremely helpful. I have only be trading futures options since 2004. I began trading naked puts, and of course did well. Once August 2007 hit, of course, I got clobbered. Then, once 2008 hit, I tried a few other techniques--and I probably just got lucky with some. For the FEB cycle, I put on a covered put the Friday before MLK's B-day. Made a nice profit in that one day--or should I say half-day. Then tried it again in the MAR cycle, and it failed, for IV dropped and the market moved against the trade. For the APR and MAY cycle, I traded short straddles successfully. For the JUN, JUL, and AUG cycle, I traded short IB's successfully. Of course once the volatility took off in SEP, OCT,NOV--I traded IB's and a diagonal bull put spread, all of the trades failed. As you know, the market took a swift and deep drop, which killed the diagonal and the IB's. For DEC, I started trading deep OTM bull put spreads, for I believed that IV would begin to fall. I would have done an IC or an IB, but I believed that there would be too much upside movement. I understand the proper place for all of these trading techniques better, and I do appreciate your analysis of diagonals. When I traded deep OTM puts earlier, I believed that I could carry over that technique to bull put spreads. I do not use the long as an automatic stop-loss. If the spread value reaches a certain point (1 to 2 times the initial credit usually), I exit the spread. As you mentioned with comfort zones--I am most comfortable being deep OTM, but I do understand your rationale.
You are certainly experienced enough to make good decisions. Choosing the right strategy for the current market is always a challenge and it's good to see you do not stick with a single method. Mark
How do you handle the situation when a bull vertical call spread loses value due to a drop in price of the stock? Could you BTC the short leg and replace it (STO) with a different earlier month short call, resulting in a diagonal or calendar?