I have been trading options for the last two years and have recently started employing a reverse diagonal spread strategy in sim mode. In my virtual trading, I have been quite successful and am thinking of employing it live. What are the drawbacks of this strategy. An example for all to comment on follows: XYZ Current Share Price: $100 Buy 500 Jan $130 Calls @ $0.82 Implied Vol: 57.5 Sell 500 March $155 Calls @ $0.86 Implied Vol: 52.6 Typical Volatility is low 40's,upper 30's. Earnings are to be announced in December. The trade (excluding commissions) nets an initial credit of $2,000. ($43,000 versus -$41,000) It appears that there is limited downside risk and incredible upside benefit, especially with a blowout earnings report. If you were to have an exit date of between 12/24 and end of the month, it is hard to see how you could lose much, especially when considering the upside potential. Thoughts?
Since I seldom do small lots ( 500 contracts ) like yourself..... my thinking is that you may want to think about starting with 1 contract. Hope you have the margin.....i believe most firms look at the backside of your trade as being naked. Also what possibly could go wrong with the trade you are looking at ......it almost appears to be risk free.....( and they claim that options carry risk......who knew ) ? I have been trading options for 2 days now and it seems to be easy money.
Drawbacks? Near month expires near strike for a total loss on your long leg (-$41,000) while your short/naked position more than quadruples in value against you. For some reason, IV expands, further magnifying your losses. Margin increases as the underlying increases and as the premium increases. Uh huh. It sure is hard to see how you could lose much with this position. I wonder why there's an initial margin requirement of over 1/2 a million $$$ for this "little" position???
Yours is a short vega, negative theta strategy. On Dec 28, which is 20 days from Dec 8, if nothing else changes, your trade will incur a loss of $16288.25 just from the time decay itself. If IV jumps suddently tomorrow, you will incur more loss. See attached graph
Thanks for the replys. I knew there was something I was missing (actually alot). It seems if you were to only hold for a week or two, through an earnings release where the IV would theoretically drop rather steeply, you would be in a position to realize limited loss. One point I failed to consider was the B/A spread in entering and exiting the trade. I am glad I am only Sim trading this strategy now. Also, I did not think appropriately about the margin requirements. Thanks everyone.
Why not do what I do. I sell puts on GE and SPY and if I get assigned then I sell calls on them. I keep it pretty simple.
If you're going to play volatility contractions via earnings announcements, you might consider selecting positions that achieve that better. AFAIK, reverse positions (single and double calendars, diagonals etc.) are more more suited for EA's in the last week before expiration so that your near month long leg costs peanuts.
At the time you are assigned, the calls you try to sell will look so cheap that you might change your mind about selling them. Also remember the reason you sell puts is because you are somewhat bullish on them to begin with. So what you just described is one of those trades that sound fine on paper, but really work in the real world.
I sell puts on stock instead of buying it because I cannot guess the best price. At least I collect a premium if I do not get it. If I do get the stock I do write calls. It seems to work so far. Better than just buy and hold.
I would be very careful with this "strategy". There are too many similar stories where it seemed so easy to pick-up a few coins here and there until there comes a time when all your gains and more are given back in a short period of time. It seems that this same story/history repeats itself over and over. The problem is, it is not the "strategy" that produces the profit, it is your "edge". This "strategy" is like laying $200 to win $10 on a big favorite. You expect to win a lot of times but when the dog wins, it takes all your previous profits and more away. Joe.