11/23 Advanced Training Lab Notes

Discussion Notes
11/23/09
Diagonalized Put Spread

In the last several weeks we've discussed calendar spreads. Eva had a great question: what if the market is bearish and not neutral? How can I make a similar trade while compensating for downside movement?

The way you do it is by diagonalizing your calendar spread. A traditional Calendar Spread construction is where you buy a longer term option and sell another shorter term option at the same strike price. You can open your risk graph by staggering the strike prices to where the put you buy is at a higher strike than the put you sell.

Bear Put Diagonal Spread

1. Philosophy

a. Enter these trades when you believe IV will build.
b. 3-6 weeks before earnings releases IV starts to build for most companies.
c. Use Earnings.com and go 6 weeks out and find your candidates. Research them using the excel spreadsheet we developed.
d. This trade is based on the idea IV will build, time will pass and the stock will most likely fall. It is a slightly bearish trade.
e. You do not want to hold through earnings. Always get out before hand.

2. Construction

a. Buy a longer term put option and sell a shorter term put option
b. The long put option should be 3-9 months in time (default to 3rd or 4th expiration choice) at a delta around .50 ~ .70 (which will put you slightly in the money, generally you can go to the first or second strike higher than the put you sell.)
c. The short option should be 1-2 months in time (only use the front month if the amount of time you’ll be in the trade doesn’t go beyond its expiration.) Sell the put option at a delta of .30 ~ .50. This will put you at or slightly out of the money on the sold option.
d. Don’t spend (this is a debit trade) more than 1-2% of your account in buying power effect.
e. The leg you sell (shorter term) needs to be worth at least .50 cents.

3. Management

a. Set a profit target based on 3 weeks of time passing and the assumed IV build you expect in the stock and the price range you believe the stock will trade at. Remember this is a slightly bearish strategy the reason you chose the put diagonal over the other calendar type spreads is because you believed it will go down. Don’t factor an upside move into your profit target analysis. Just look at the sideways and downward price slices.
b. Here are some other management techniques to use if you don’t hit your profit target:
i. Watch the risk graph and the stock chart. If the price moves outside your breakeven points look to exit the trade.
ii. There isn’t a specific delta rule on this trade like in the other trades. The main reason is that this strategy has structured risk to begin with. Your cost is your risk and since you’re only spending 2% of your account you can be patient.