I have some questions about this strategy that I have looked at extensively. I have a trade: DEC08 ES is the underlying; Short NOV08 795P; Long DEC08 700P. Net credit was 6.00. The greeks: Vega-Neutral; Theta +4010; Gamma -0006. As I compare this spread with a short, naked NOV08 795P, I see the following: Theta is still positive, but less positive than the naked short; Gamma is negative, but less negative than the naked put. Some observations: It appears that the NOV08 will decay faster than the DEC08 because of theta. It appears that long volatility is neutralized. So, am I correct in believing that this spread simply makes money over time, regardless of the movement of the volatility? So, what am I missing? How does this trade lose money? It seems that the max profit is seen near/at the 795 strike at NOV expiration. How/where do the losses occur? Extreme volatility movements upward? Extreme volatility movements downward? Extreme price movement upward? Extreme price movements below the 795P? I appreciate some insight.
You're pretty well covered for all scenarios I can think of except one - a giant drop in the ES. The sooner a big drop occurs, the worse for you. If there were a big drop in the next few days and your short Nov. put exploded in volatility and your long Dec. put lagged behind (IV did not go up as much), that would hurt you. Since the vega on your short Nov put decreases every day, as Nov expiration approaches, your danger of loss in such a scenario decreases. By Nov expiration you're pretty safe down to about 700 or so because your long 700 puts would explode in value (IV) in such a move, and the short Nov puts would no longer have much vegas left.
There's also the possibility of a slow drift downwards in which IV gets crushed. If ES finish about 25 (or more) points ITM, a huge IV drop will kill the value of the Dec options. Mark
Theoretically possible, yes. But 25 points ITM would put the ES at 770. If the ES gets down that far or further in the next 30 days, the probability of a huge IV drop is extremely low. Negligible really.
I appreciate everyone's comments. I have a couple of additional questions for the group. 1. What would be a reasonable stop-loss for the above trade? 2. What is a reasonable expected profit for the above trade? 3. When would you enter a diagonal calendar put spread for a credit vs a diagonal calendar call spread for a credit? Would you enter a put spread during an overall uptrend or downtrend? Same for the call spread? 4. I would enter these trades within 30-45 days of expiration of the front-month leg. On a daily basis, when would you enter the trades? At the open? End of day? As the daily trend moves upward for put spread? As the daily trend moves downward for call spreads? Again, thanks for the comments.
You got a good trade except this: 1. what are your contingencies for margin increeases due to price going lower or due to brokers raising margin requirement? The point here is that your do not want to be taken off your position midway. 2. Your ideal case (if you keep till Nov expiration) is that the price finishes at short strike. Have you considered moving the short strike (and long strike) a bit higher?
Bump this discussion up for more input. I am not able to figure out what a reasonable profit would be on one spread (short strike was 25; long strike was 19, for a $6.00 credit. What is a reasonable stop loss for this trade given its potential? During the day, when is the best time to enter the put diagonal [bearish] spread? Should it be entered when volatility is low? or high? How about when the market is oversold vs overbought? Appreciate any thoughts; did a google search on this subject and basically came up empty-handed.
Orderly sell-offs have not lately been met with IV explosions - it has been typically the opposite, so in the event of a slow drift downward over the next month or so, vols don't necessarily have to continue to rise. Moreover, in the alternate downward scenario - a violent continuation of the recent sell-off, time spreads might continue to contract, as near term options go super-bid on gamma plays and options with more time to expiration are sold to cover those buys. What you do have going for you is that we're entering a five-week expiration cycle, buy-writes are contributing to the typical front month vol crush, the VIX has appeared to peak, and already you're reaping the benefits of being short front month on such a high vol. Today's vol crush alone must have reduced the premium value of your NOV shorts by $3 or $4 I'd imagine. Hope some of those explanations made some sense! Good luck
I am attaching a 30-min chart (each bar covers a 30-minute period) for the last 25 days comparing the S&P500 (top) against the VIX (bottom). I don't see a single case where the S&P 500 sold off and the VIX sold off too. Quite dramatically the opposite (except for what is obviously a data glitch in one bar on 10/10). Anything can happen and it's theoretically possible that the S&P 500 could sell off to 770 - the low from 2002 - and the VIX sell off too. But trading is about probabilities and I cannot think of a scenario more unlikely than that.