Sunday, September 1, 2013

follow the money ... trade bear put diagonals

deep throat: follow the money.
bob woodward: what do you mean? where?
deep throat: oh, i can't tell you that.
bob woodward: but you could tell me that.
deep throat: no, i have to do this my way. you tell me what you know, and i'll confirm. i'll keep you in the right direction if i can, but that's all. just... follow the money.
-all the president's men (1976)
spy put diagonal, time unit-cost is  .48/week (3.35/7)
i am in the calendar vending business. selling a calendar is what happens when one rolls a shorted option from one expiration period to the next. this nets a credit because, in the option world, time-is-money and the same strike option with more dte (days-to-expiration) is generally worth more money.

the problem is that markets move. the price of the underlying can move far from the strike of my short option and this reduces what i can collect on the roll when the time comes. so it behooves me to heed deep-throat's advice and follow-the-money so as to be rolling shorted options that are as close as possible to the underlying's price as expiration draws nigh.

the bear-put-diagonal helps with this problem because it is such a flexible trade. when time has run down on the shorted option, the bear put diagonal can almost always be adjusted in such a way that the shorted option ends up closer to the money yet the adjustment still nets a credit.

i initiate my bear-put-diagonals on the eve of earnings reports. this is when implied volatility will be inverted - the near term options price way higher than the remaining time warrants due to event risk. i prefer equities with weekly options because there are always soon-to-expire options available when earnings come due for reporting. often-times my bear-put diagonals are profitable the next day because of the crush in implied volatility that occurs post-event.

to initiate the trade i sell the first otm strike in the weekly options and purchase the first itm strike in an expiration that is 90 or so days away. the near-term option should price something like 50% of the far-term option. the reason for the 90 days is that that purchases time in bulk. the option market naturally discounts bulk purchases of time in proportion to the square root of remaining time. this makes it possible to sell time in smaller chunks in the form of week-to-week calendars, via roll transactions, that add up to more than the bulk purchase. one can think of this as a wholesale/retail business except the product being vended is time.

higher priced stocks are more efficient, commission-wise. i generally prefer stocks above 30 for bear-put diagonals since i am paying two commissions per diagonal and these higher priced stocks tend to be better quality companies anyway.
i always purchase the put diagonal in multiples of 3 or higher because, if need be, this facilitates morphing the trade into a backratio. this is how i adjust the trade for a stock that gaps-up big.

the risk of the bear-put diagonal is limited to the purchase price of the trade. the trade may post a loss initially on gapping behavior but after following through with adjustments and rolls it is hard to envision a situation that would lock-in a full loss for a 90 day duration. still, i size my trades so that the full loss is a small acceptable portion of my account.

after acquisition i rest a gtc limit order to sell at 25% gain. this is the goal. also, i make note of the unit-cost of time by dividing the cost of the diagonal by the number of roll opportunities. the next day, after the vol-crush, if the trade is profitable but the gtc order has not filled then i close the position at market. otherwise i manage the trade for the long haul and this means dealing with gapping behavior after earnings.

if the underlying has gapped up then when the shorted puts are nearly worthless i buy them back and sell the next week's options usually at a higher strike closer to the money. one can always morph the bear diagonal into a calendar, with no additional risk, by selling the same strike as the far-term put. selling strikes higher than the far-term put is possible too but increases the risk in the trade in proportion to the difference in the strike prices. when chasing the money two or more strikes above the far-term put's strike price i sell one fewer option than i bought-back. this morphs the trade into a backratio. if the market subsequently sucker-punches me with a sharp reversal then i have the extra long-put that will at least ease my pain if not drive the trade to profitability, depending on how vol expands. the rolls of two atm short puts more than pays for three long puts.

if the underlying has gapped down on earnings then there is usually some way to roll the whole position down for a net credit. re-establishing an atm bear-put diagonal is preferable but, if that fails to generate a credit, then i consider morphing into a calendar, a bull-put diagonal or a backratio. shifting the long put down more strikes than the short put is a powerful engine to generate credit especially because this works in the direction of volatility (ie lower prices in the underlying increase implied volatility.)

it has been my experience that equities tend to stabilize after gapping on earnings. so after the post-earnings adjustment the trade management typically devolves into the business of rolling options. my bear-put-diagonal-earnings trades have moved the meter on my account and have become my go-to trade. i plan to share a few of them on mytrade in the near future.

happy trading to you.



  1. Can you comment on success over the time period since posting?

  2. Hi Allen,

    Just curious on what your actions would be if the Put was assigned before you could exit at 25%. Would you convert it back to the original diagonal position, exit entirely, or leave the stock + put position on until the hedging leg expires?