Part 4 of 4: Managing SPX Diagonal Spreads

For the fourth and final segment of this series on SPX SUPER LEAPS®, LEAPS and Weekly’s, we’ll take a look at managing the Diagonal Spread that we put on last week. As a quick refresher, we have a long SPX December 16, 2016 1875 Call with a cost basis of $17,200. Against this position we  sold the SPX August 1, 1990 strike call for a credit of $350, creating a Diagonal Spread.

sh 1As you can see in the chart above, the SPX has been hit hard this week losing 50 points since when we put on the short leg. With the SPX trading 70 points away from the short call being in-the-money, there is little risk of an assignment. Therefore, we can focus our attention on rolling the position into the following week. The SPX has dropped 2.5% and downside volume has pushed to one-month highs.

Here’s where the trader needs to make a decision about how to manage the position. There are several choices based on an analysis of the current market and where the trader feels the market is headed in the immediate future. Here are the actions for each “opinion”

#1 “This is the start of a correction, it’s time to take profits”

If this is the opinion then it’s best to close out both legs of the spread. The trader can do one of two things to close out. He can wait until the short leg expires and then sell the long leg (the SPX Super LEAPS trade until 4:15 Eastern) quoted @ $20,080 below.

sh 2If he wants to close out the position prior to the short leg expiring then he can “unwind” the position by creating a spread in which he buys back the short leg (for a few dollars debit) and simultaneously sells the long leg for a net credit to his account.

#2 “I think this is temporary and the SPX will rally next week and be back up to these levels (1975)”

Although technically the markets don’t support this opinion, it’s an important point to discuss. Since the SPX has retraced 2.5% since we sold 1990 Weekly we cannot expect to get the same $350 credit we did the week prior. To illustrate this point let’s assume that we can buy back the 1990 short leg with just a few hours to expiration for $5 and simultaneously sell next week’s 1985 strike call for $30 we would net just $25 less commissions. This process is called a “roll”. In this case we are rolling the position from a 1990 (Aug 1) to a 1985 (Aug 8) call, so it’s a “Roll Out and Down”.

sh 3

#3 “I think the market has hit a rough spot for the next few weeks and will slowly come back in time”

Here’s where being a skilled technical trader will pay off. If the trader assumes that the market is going to continue down for a short time, find support and then move higher he can roll the position out and down and generate a healthy credit to the account. If the trader were to sell the Aug 8 1935 strike call for $940 while buying back the Aug 1 1990 strike for $5 he would produce a credit of $935 for his account (a 4.7% ROI to sell an out the money call).  No additional margin requirement with owning a Dec. 1875 strike call and being short an Aug (8th) 1935 strike call. Of course if the market come roaring back his short leg could end up in the money. Gamma risk is a very real possibility since this trade only has a .1% upside cushion. Gamma Risk is explained at the end of this post.

#4 “The markets have been resilient recently. I think the market will quickly find a bottom and head back up, I’d like some income but I also want some upside for the long leg and avoid Gamma Risk”

In this case a trader wants to produce some income but also allow the SPX to have some upside movement. Strike selection here is critical. Selecting a strike too low and the position could be caught in the money at expiration. Selecting a strike too far away and the trader is giving up income unnecessarily. A technician will typically sell the strike that is just above recent resistance. Back in June and July the 1950 level acted as both resistance and then support. This point is often called a “role reversal”. For this example we will use this role reversal point of 1950 as our short leg in a roll out and down set up. This would generate $415 of income for the position and allow for the market to gain 1.7% over the next week without the risk of assignment. sh 4

Gamma Risk:

One of the things all traders utilizing multi-leg position need to be aware of is Gamma Risk. To understand Gamma Risk a trader needs to have a basic understanding of option greeks. I’ll provide a quick and rudimentary example here. Gamma risk involves two of the option greeks, Delta and Gamma. Delta is the expected rate of change for the option relative to the change of the underlying. At the money options typically have a Delta of .5, in the money >.5 and out the money <.5. Delta will change as the option moves further in or out the money. Therefore if the underlying were to move up $1 we can anticipate the call option will increase by @ $.50 (the at the money put will decrease by @ $.50). If the underlying were to drop $1 we would expect the option’s value to decrease by $.50. The Delta gives us an idea of what will happen for the first dollar’s move up or down, it doesn’t tell us what happens as the option moves more in or out the money. This is where the Gamma comes in. Gamma is the rate of change for the Delta. Using our at the money example above the same option might have a Gamma of .15. Therefore the option’s Delta starts at .5 for the first dollar higher and then changes by the Gamma of .15. For the second dollar increase in underlying the Delta is now .65 and so the option’s value increases $.65 for the second dollar. For the third the Delta is now .80.

Gamma’s are larger for near term options than they are for options with longer term expiration. Because of this the Delta of two at the money strike prices will differ depending on the time to expiration. For example. Stock is at 192.  The 194 strike Call with 4 days has a Delta of .175 and a Gamma of .122. The192 Call with 6 months has a Delta of .52 and a Gamma of .03. This Diagonal Spread starts out Delta positive but can quickly turn Delta Negative. Here’s how the position would play out if the stock moves up 5 points starting with $192.

192–193-194    strike Delta .297   192 strike Delta .55     Position Delta + .253

193 – 194  194 strike Delta .419    192 strike Delta .58    Position Delta + .161

194 – 195 194 strike Delta .541     192 strike Delta .61    Position Delta + .069

195 – 196 194 strike Delta .663     192 strike Delta .64    Position Delta – .023

196 – 197 194 strike Delta .785     192 strike Delta .67    Position Delta – .115

This is a crude example of Gamma risk and the effects on Delta but it should illustrate the point; option values are not in sync with one another, especially when the time to expiration is different.

We mentioned last week that the real challenge of the Diagonal Spread is the required maintenance of the position. As expiration draws near, a trader will need to decide what to do next, will he roll the position and if so, will he roll out, up or down? Will he close out the position entirely or will he keep just the long leg for the time being? In order to fully benefit from the flexibility of a strategy like this a trader will need to be comfortable with the many ways to morph his position.

We consider diagonal spreads to be a more intermediate strategy and we assume some of our more rookie traders may have been lost along the way. If you are one of these traders and would like to reinforce/refresh your knowledge of basic option strategy with us at Pro Market Advisors please visit our website for additional educational resources.  SH.

*None of the examples include commissions and fees.



  • Darlene Selena Williams

    Does this pertain to SWAPS and other risk exposures?