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CM Strategy

Optionalysis: Introducing Diagonal Put Spreads, Through A Current Trade in StratOptions

Optionalysis

In Optionalysis today we look at a Diagonal Put Spread that we have been trading, in Stratoptions.

A few days back we went ahead and did this trade:

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• Sell the Nifty 7200 put (March expiry) at Rs. 60

• Buy the Nifty 7000 put (April expiry) at Rs. 60.

This is a put spread – and since we sell the Nifty 7200 and buy the 7000, it’s semi-bullish. But the fact that it’s of different months, makes it a diagonal (a calendar spread at different strikes) spread, so it’s not purely bullish.

The payoff here is complex: you can’t easily plot it because even if the March option expires on March 31, you still have an option for April available and open. Here’s what OptionsOracle shows it to be:

Diagonal Put Spread

The idea is to look at three different scenarios, as of March 31:

  1. The Nifty stays above 7,200. In this case, the sold put will expire worthless (so you get the full Rs. 60 premium). Depending on where the Nifty is, you will see some remaining time-value on the April put (which you have bought). At this point, even if the 7200 put for April is only Rs. 6, your profit per lot is Rs. 450. Or, you can think of it as: you get a Nifty 7,200 put for free for the month of April in this scenario.
  2. The Nifty closes at 7,200. You make the max profit here. The short put expires worthless, and the long put has some time value – in this case, it’s assumed to have about Rs. 55 in value based on an IV of about 18. (At 7200 the Nifty 7000 put, expiring one month later, with an implied volatility of 18%, will have about Rs. 55 in value). That’s your profit = Rs. 4100 or so.
  3. The Nifty closes below 7,200. Your will lose profit upto Rs. 7,100, after which you make a loss, and the loss looks unlimited, but bear with us. At 7,000 the short put will have you pay out Rs. 200 (the difference between the strike (7200) and the Nifty (7000). But at the same time the April put will have some value – let’s say it’s 130. You get that back if you sell it. So your net loss is 70 points, so you lose about Rs. 5,250.

The point is that we aren’t necessarily bullish. We’re just saying here that there is a very low chance of the Nifty breaking below 7,100 in March. If it doesn’t, we profit.

How Much Profit?

A put spread of this sort requires about Rs. 35,000 as margin, or less. Even if you assume Rs. 50,000 as margin, the max profit at Rs. 4,000+ is 8%, which meets our StratOptions goals (3 to 5% a month, or more). If you don’t actually keep it for the full month, then you will make maybe half the max profit – of say Rs. 2,000, which is 4%.

In fact we are already seeing a profit of Rs. 950 on the trade, which is a 2% profit. This happens primarily because of time decay – the 7200 put (March) decays faster than the 7000 put (April).  A sharp move down would have hurt, but that’s the risk we take.

At 7,000, we will lose approximately 5,250 which is about 10% on the margin. That would require the Nifty to fall about 500 points from the 7500 levels today.

In Stratoptions, we’re playing through risk-reward, and what is usually thought of as “unlimited loss” is a scenario that is an ultra-extreme, like a 10% gap down. We understand these will hurt a lot, and at best we can take precautions before large events, or reduce exposure, but in the absence of such a move, we should profit.

How To Choose the Strikes, and When

Why choose 7200-7000? The choice of the first strike can be based on a strong support or resistance level. In our case there were a couple of good reasons to choose the 7200 level as a bounce level for the Nifty – the gap rise from there is a weak support but two flips from this point in the recent past show a strong support area as well.

Nifty

And then, why the April 7000? Answer: it was trading at the same premium as the 7200 put March. That gives us a net zero cost for the spread.

Also, 7000 is a good support level as well, and if that support holds the market goes back up to 7,200 which is our zone of profit. Finally, the 200 point spread is decent – about 3% of the Nifty – which reduces our risk on the position.

The “When” is more complicated. You benefit with time decay. So have between 30 and 15 days to expiry before you take such a spread, for the closer month. Typically when there’s less than two weeks to expiry, the prices won’t work out or introduce a heavy risk. (Right now, for instance, the corresponding spread would be 7200-6800 (for a price match) which is 400 points of losses – that would stretch our loss to over 10,000 (or about 20% of margin) which can be disastrous. We wouldn’t write this spread today, but after the March expiry we might see a good strategy in the April-May diagonal.

Note also that you shouldn’t do this spread when the IVs are too low. If you want to benefit from time decay, it’s better to do puts and it’s better to do them when IVs are higher than average; for the Nifty, a low IV would be below 16.

Adjusting the Spread

If the Nifty hit 7,200 very fast – say tomorrow – what would we do? The answer will be based on data then. First, when markets fall suddenly, the IVs go up, and that will increase the price of the April put a lot more than the March put, because there’s more time value remaining – and the spread loses less money. However we can adjust the spread at this time in multiple ways:

• Write a call spread (7400-7600) if IVs are high enough, for March.

• If the market is weakening further, buy back the March put and keep the April put to profit if it goes weaker (this becomes directional)

• Square off the position and take the profit/loss.

Every day that the Nifty doesn’t hit 7200 means the losses for such a move the next day are lower. Today, at current IVs, we will have no losses if the 7200 level is hit tomorrow. In a few more days, we might actually see profits on a next-day move. And so on.

Early exits to such a strategy do not work well, since its primary function is to work through time decay. The primary idea – that the Nifty stays above the upper put level – should however remain valid. If the technicals indicate a sharp down-move that will break that assumption.

Summary

A diagonal put spread can be executed at a price point where there is a strong layer of support, when IVs are higher than average, and there is enough time decay.

Avoid big events, and look to adjust or exit only when the basic assumption behind the spread is violated.

You could play this for a 3% move and exit if that objective is reached earlier.

Doing this on indexes is better than on stocks, as indexes tend to be less volatile (and more liquid in the longer option).

Don’t think of this as low risk, but it isn’t as high as one imagines by looking at a payoff graph alone. (After all you risk dying of dengue every time a mosquito bites you; but do you always carry mosquito repellant?)

We’ll summarize the Diagonal when we exit, but we hope this gives you perspective.

Past Posts in StratOptions:

• An Option Strangle That Got 2% from a Post-RBI-Meet-Time-Decay Trade

• Introducing StratOptions as we get a 3% from a Calendar Butterfly Spread

• A Bet on a Low Vix Gives Us 4% in January

• Modifying a Straddle Into an Inverted Strangle Gave Us 3.4% More To End Jan With 7.43%

• Feb 2016: In the Volatility, We Make 3.5% After Some Intense Effort

All trades are on Slack, in #actionable. Discussed in meticulous detail in #options.

(Trial members: you will get access to both the real time chat and to archives when you subscribe)

Note: No matter what we say about curtailing risk, there is risk. It cannot be avoided. We will have loss making trades in this strategy at some point, and we will see big hits to the portfolio. Let’s be aware of this risk at all times. Do not attempt this if you will be devastated with a loss – even a loss that’s quite big in comparison with the winners. (If we make 3% we might lose 10% in a trade; we have to try hard and lose a lot lesser than we win)

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Disclaimer

Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion. 

Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.

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