iCharts Discussions

[SwingTrader]

Diagonal Spreads

I will start posting in installments some educational stuff about options based on how I trade. This may or may not be in line with what is given in various books. Questions/criticism are welcome. Basic knowledge of options trading terminology will be useful. I can't post something simpler than this as it would get quite long. So please read up about options first if you are new to options.

NOTE: These are my views only. These are not the only way to trade options. Consider them as educational ideas only. Experiment by paper trading etc before using any of this info.

Terminology Used:

Long Option : A trade where one buys a call or put.

Vertical Spread : A trade where one buys an option and sells another. Example: BUY NF 6000 CALL + SELL NF 6200 CALL. This is a bullish call spread.

Diagonal Spread : A trade where one buys a far month option and sell a near month option. Example : BUY NF JAN 2014 6200 PUT + SELL NF DEC 2013 6000 PUT. This is a bearish diagonal put spread.

Most of the time I trade either vertical or diagonal spreads. I use verticals when there is not much time left for near month options to expire. Majority of the time (when there is 2.5-3 weeks or more left for near month expiry) I trade diagonal spreads.

I will explain below why I use diagonals most of the time. I will start with long option, then go to vertical spread and then to diagonal spread to explain the differences and pros/cons. The reason for trading diagonals is risk management. If you look at the price of options, it would look like an out-of-the-money (OTM) option is the cheapest. But the issue with these options is that there is only time value in its price and that can vanish very quickly either with time or by a price move against it. Trading a small OTM options position is fine but deploying decent amount of funds in such options is extremely risky and such positions are extremely difficult to adjust when required. In short, OTM options are very low probability trades. In-the-money (ITM) option could be used but the funds required would be significantly more. Below is an example of a trade. Let us see how it would fare when various options strategies were used.

I will use a failed trade as an example because risk management is my primary focus, profits are secondary consideration. I initiated a bearish trade on 30th Sep based on NF OTM PCR rank signal followed by price breaking support. On 9th Oct I exited the trade as the signal was negated.

I will be using EOD prices to keep things simple. This will be close approximation as I usually initiate trades between 3:00 and 3:15 PM only.

1. Long option (BUY NF OCT13 5900 PUT @ 222.10)

On 30th Sep NF closed at 5791.45. This is an ITM option. Here is what happend:



I would have lost 60% of the amount. An OTM option would have lost more percentage wise. I am concerned about the money lost percentage wise as that is what I will have to look at when deploying large position size.

I had actually used a long option to trade this signal. This was for simplicity as I was just testing. But I would not even think about this when trading a large position.

2. Vertical Spread (BUY NF OCT13 5900 PUT + NF OCT13 SELL 5700 PUT)

In this case we are using the same 5900 PUT used earlier but we are also short 5700 PUT which will act as a sort of hedge but will also limit profits. The max profit in this case will be difference in option strikes (5900 and 5700) minus the trade debit (amount used to buy the spread - 5900 put cost minus 5700 put cost). I am fine with limited profit as we are talking only about a month's time when trading options anyway. Here is how this position fared:



Much better, especially for people like me who are wrong most of the time. You don't lose much if trade goes against you. The percentage loss has been computed on trade cost + full margin required to hold the trade.

3. Diagonal Spread (BUY NF NOV13 5900 PUT + SELL NF OCT13 5700 PUT)

This is my favorite - the diagonal spread. Here we buy the Nov 5900 put and short the Oct 5700 put. Do note that the cost of this trade will be higher due to more premium required for the next month long option. The advantage is the higher positive theta of the short option and lower negative theta of the next month option when compared to vertical spread. Here is how it fares:



One does not lose much in this case. The added advantage with a diagonal is that it will profit lot more than a vertical spread if one is right about the direction. It will profit little even if price does not move or moves a bit against you too.

Every strategy has disadvantages. The disadvantages of diagonal is (other than the limited profit which is actually fine with me) that if NF volatility falls then it will not profit that much. This is because diagonals have higher vega compared to verticals. But I am fine with that, falling volatility only increases the amount of time required to profit. If price does move in our direction the position will be very much in profit.

For all the strategies there are lot more combinations. One can use ITM, ATM, OTM options for longs and this will drastically modify the profit/loss of these strategies. I like to use ITM options for longs as they have lot more intrinsic value in it and lower time value. In other words, they decay less everyday. The combination I have shown above (ITM long + OTM short) is the combo I use all the time for spreads.

I have highlighted a failed trade first because we need to take care of the risk first. Profits follow automatically if risk is handled well.

In the next installment we will look at a winning trade so we can compare the profits of these strategies.

[SwingTrader]

2. Long Option vs Vertical Spread vs Diagonal Spread (Profitable Trades)

In installment #1 we saw losing trades, this time let us see how these strategies perform when we are right about the trade.

One important point : Even though the focus of these lessons are diagonal spreads, one should look at all strategies openly. The idea is to pick the right strategy for the right setup. Long option is quite risky as there is no downside protection/hedge but if one is really confident of the trend and is ready to adjust the trade (to a vertical spread) once it is in profit then it also could be employed. Vertical spreads are extremely versatile and I use these all the time, especially when there is not much time left to expiry (so diagonals can't be used - this is Indian market specific condition). Diagonals are good especially when volatility is low as its profits get amplified if volatility explodes (vertical also will be excellent in such cases).

The profitable example I am taking here is well chosen based on hindsight. But it is also a signal I had taken based on NF OTM PCR Rank. On 2nd Aug price broke down below a support and rank had already indicated clear bearish bias few days ago. Volatility exploded and would have benefited all long option trades. Here is how the strategies performed. NF closed on 02.08.2013 at 5705.55.

Long Option (LONG NF AUG13 5700 PUT)



There is no argument about this strategy. If one is right about the trade then long option works like nothing else. But this strategy is tolerable only if one is trading a small position size as the losses or drawdowns can be stomach churning.

Vertical Spread (LONG NF AUG13 5700 PUT + SHORT NF AUG13 5500 PUT)



Here we don't have sky reaching returns like long option but we also don't have the stomach churning moves against us. Any systematic trading plan should consider verticals as one of their core strategy.

Diagonal Spread (LONG NF SEP13 5700 PUT + SHORT NF AUG13 5500 PUT)



Similar to vertical spread. But this strategy will have lower losses if the trade goes against us. And they will benefit more if volatility explodes (due to the larger vega of the trade due to the next month long option). Profit will be slightly more than the vertical spread. This is not too clear here but as we will see in many other examples I will post in the near future, diagonals profit more in general and lose lesser than verticals.

But I concentrate on both because in the Indian market we can initiate a diagonal only in the first week-to-10 days after expiry. I am talking about NF only. Since we have only three active months and out of those only the first two months will have real good volume, for all practical purposes we don't get much time to initiate diagonals. In the US market there is great flexibility in trading diagonals as there are hundreds of liquid scrips and many many months that are liquid enough to trade.

About trade costs and margins - The trade cost + margin for both verticals and diagonals comes to almost the same. For verticals the trade cost is going to be less and margins are higher (than diagonals) and for diagonals the trade cost is higher (than verticals) but margin is lower.

Profits - The way I setup vertical and diagonal, max profits most of the time are around 20%. If volatility explodes then we could see 25-30-40% profits but once profit goes above 20% I am very careful.

Profits can be greatly amplified if one takes out-of-the-money long instead of the ITM long I strongly suggest. But this carries lot more risk as the loss can be high if trade goes against us. ITM long and OTM short is preferable for both verticals and diagonals.

Diagonal strike selection - I will go into this in detail with examples but here is a quick idea. I try and make sure I get a minimum of 30% hedge for my long option when trading a diagonal. Eg. see the above trade, long option is priced 158.05 and short option is priced at 54.85. So short option price is around 34.70% of the long option. This is okay. Anything less than 30% is a problem as it would not provide adequate hedge. More hedge you want the lesser profit you get, less hedge you take the more potential profit. But same goes for losses, more hedge - less losses and less hedge means more potential for loss.

More coming later this weekend....questions are welcome in the meantime.

[SwingTrader]

3. Long Option vs Vertical Spread vs Diagonal Spread (Going nowhere / sideways range trades)

Let us now look at the performance of these three strategies in a sideways move.

I am deliberately picking the range from 10th Sep 2013 to 26th Sep (expiry day) because this was a sideways range overall and would help us in analyzing the performance of these strategies in a sideways move.

Long Option (LONG NF SEP13 5800 CALL)



Long option is all over the place during the sideways move.

Vertical Spread (LONG NF SEP13 5800 CALL + SHORT NF SEP13 6000 CALL)



Vertical makes sure we don't lose much in this sideways move but we still eventually face a loss, though it is not much.

Diagonal Spread (LONG NF OCT13 5800 CALL + SHORT NF SEP13 6000 CALL)




Diagonal shines brightly here. It does not have a negative day through out the trade.

Why does the diagonal work so well in the above trade whereas the vertical does not?

1. The long option in the diagonal is the next month option which has lot more time value due to more number of days left to expire. So even at SEP expiry it will still have lot of time value left. This also means the long option in a diagonal loses value due to time decay at a much slower rate than the long option in a vertical (long option in a vertical expires along with the short option).

2. The short option in a diagonal loses time value at a much faster rate when compared to its long option. This is because the short option is going to expire lot sooner than the long option. In addition to this, the short option is also out-of-the-money which makes it lose value faster than the in-the-money long option.

Due to the above two points we have lots of good things going for the diagonal:

1. The diagonal will lose less if the trade goes against us

2. The diagonal will profit a bit more than vertical if the trade goes in our expected direction

3. The diagonal will profit if price just goes sideways (but stays atleast a bit above the long option strike price)

[SwingTrader]

Example time....

Those of you who have checked my market sentiment thread might remember that I had taken a bearish put spread trade on 12th Nov to test a bearish OTM PCR signal. I closed this trade for a tiny profit of around 4.5%. Below is the P/L summary of the trade compared with a hypothetical diagonal that could have been used instead.

I am using EOD prices for both as I had initiated the vertical spread around 3:15 PM on 12th Nov and EOD prices are almost the same.

Vertical Spread (LONG NF NOV13 6200 PUT + SHORT NF NOV13 6000 PUT)

My actual spread : 6200 PUT @ 162.35, 6000 PUT @ 61.60



Diagonal Spread (LONG DEC13 6200 PUT + SHORT NF NOV13 6000 PUT)



The diagonal would have been better. I could have closed the trade for around 10% profit instead of 4-5%. The above stats indicate P/L until 28th Nov expiry day. I actually closed the trade on 27th just before market close.

The diagonal spread pricing may not be good to initiate a trade just two weeks before expiry. I try and get a 35% hedge for my long option (short option price divided by long option price in %). But at times I take the trade if % hedge is 30% or more. 30% is surely the lowest I take. If this hedge % rule is followed, one can stay out of big trouble.

30% hedge is sometimes difficult for CALL spread but quite easy for PUT spreads as OTM puts usually are expensively priced as they are used to hedge portfolios and are thus more in demand.

One more important thing to remember. The diagonal's greatest risk will be within 4-5 days of trade entry. This is because time decay would not have started eroding the short option premium by that time. After 4-5 days of entry, the trade starts to strongly swing in our favor (I mean in terms of risk. risk starts to go down 4-5 days after trade entry).

I will post more detailed diagonal trade entry criteria/guidelines later.

[SwingTrader]

[SwingTrader]

4. Effect of volatility trend on diagonals

Diagonals have higher vega (the option greek that gives an indication of how much an option can move if volatility changes) due to far month long option we hold. Far month options are affected more due to changes in volatility than the near month ones. So if volatility decreases significantly when we are holding a diagonal then our losing trades could lose significantly more than they would have lost if volatility had stayed stable. For winning trades the degree of profit will get reduced.

Assume we just closed a losing diagonal trade and on analyzing we found that volatility was stable throughout the trade. If the loss on the trade was around 10%, we could have lost around 14-18% if volatility had crashed. A slow decline of volatility would not affect that much but a volatility crash would affect it significantly.

For a profitable trade on which we had profited around 20% (as an example) if volatility was stable throughout the trade, we would probably profit only around 12-14% if volatility had crashed.

Volatility exploding would benefit both losing & winning trades. Losing trades would lose less and winning trades would win faster and more. We have seen examples of Aug 2013 trades earlier. Do look at INDIXVIX chart for Aug 2013, volatility just exploded like anything. The put diagonal returned about 10-12% more in this case.

The important lesson here is that one must swiftly decide what to do with losing trades. If volatility has started to increase fast and price does not seem to go in favor of our trade then it would be best to close the trade (if one is already losing significantly on the trade). Monitoring volatility is more necessary for losing trades because it can affect the degree of loss. For winning trades this is less important because if we get the direction right then it will override any implosion of volatility and we might only get a bit lesser profit. We will discuss more on this in the last lesson on managing diagonal positions.

No examples here. This is something to be kept in mind when you monitor any diagonals you are holding. For examples of volatility explosions look at INDIAVIX in AUG 2013 and for volatility implosion (decrease) look at SEP-OCT 2013.

In the next lesson we will look at rules for initiating diagonals.

[SwingTrader]

5. Trading Diagonals - Guidelines

Timing

When you are trading diagonals, you are taking a directional bet. This means timing is going to be important. There is some hedge built into the trade as a result of the short option and slower time decay of long option but rough timing is still critical because this is a directional trade. The idea is to try and see that price stays above the long option by the time you decide to exit the trade (we may even profit if price goes slightly against us). There are number of ways to decide on the direction, it does not matter which one you choose. Just make sure you stay consistent and use a single method to pick the direction. A single method is necessary for the probabilities to start working in your favor. I will suggest a method later when I post examples but it is best you choose a method of your liking.

Selecting Option Strikes

This is critical. There are various ways to select strikes like finding mispriced options and using volatility skew but I will not go into either of these methods as it will get fairly complicated. Also, since we are taking a directional trade we will profit even if both mispricing & skew are absent as long as eventually our directional estimate is roughly right.

I suggest the % hedge method for selecting strikes that I have mentioned previously. I have arrived at this method through lot of trial and error. Follow these steps for strikes selection:

*** We will talk only about NF here as no other scrip has liquidity good enough to trade diagonals in the Indian market ***

1. For long option take strike from the next/far month. Select the strike that is at-the-money (ATM) or slightly out-of-the-money (OTM). NOTE: ATM or OTM is with respect to current month futures price and not the next month (even though the strikes are being selected from the next month).

2. For short option take strike from the current/near month that is two strikes OTM from the long strike selected. Long and short options two strikes apart is optinum for NF. One strike apart and the profit will start to dip after price crosses the short strike which can be a major problem in managing the trade. More than two strikes part means you will not be able to get the optimum hedge % required (see the next point about this).

3. Compute the hedge % using the formula below:

Hedge % = (Price of short call / Price of the long call ) * 100

4. If the hedge % is above 30% this strike combination can be selected. If the hedge % is less than 30%, start the process again from #1 by going for more nearer ATM or ITM option for long and then repeat the steps and recompute the hedge %. Most of the time we end up with ITM long and OTM short which is usually the opinum combination unless one is initiating the trade close to expiry when the position has to be more ITM to provide enough protection.

5. Once you have a strike combination with hedge % greater than 30%, it can be used to enter the trade.

Time to expiry

Try and have atleast 3 weeks to go to short option expiry. The more nearer to expiry a diagonal is initiated the more ITM it should be to have adequate protection. This is more or less automatic if one sticks to the 30% hedge guideline. Even if one tries, one cannot initiate an OTM diagonal near to expiry that still provides 30% hedge, one has to go for ITM diagonal as one nears expiry. So if this guideline is followed one usually is able to stay out of serious trouble.

Important Points to note:

1. The more nearer or ITM the long & short option strikes are the more protection you get for your position BUT lesser the profit potential.

2. The more far away from ATM the strikes are the less protection you get for your position BUT greater the profit potential.

3. I have arrived at 30% hedge after lot of trial and error. It provides an optimum balance of risk vs reward.

4. For PUT diagonals one can easily get much more than 30% hedge % as puts are usually expensively priced. For CALL diagonals one has to go more near/ITM to get the 30% hedge %.

5. Do not compromise on the hedge % unless you know what you are doing and are ready to deal with the position risk.

6. First few days after initiating the diagonal are very tricky IF price moves fast against you. Before you enter the trade, decide a % stop loss or NF/NS based stop loss. Once 5-7 days pass, the position gets better as time decay sets in for the short option.

7. Also, decide on a profit exit before you enter the trade.

8. In general diagonals will benefit if volatility explodes when the trade is on and will suffer if volatility implodes suddenly. A gradual increase or decrease of volatility will not have much of an impact on the position.

I guess I have managed to put all guidelines I can think of about initiating a diagonal. If I recollect any more, I will edit this post and add those here. The next post will be about managing the diagonal trade - targets, stop loss, when to exit etc etc. After that post I will start posting examples.

[SwingTrader]

6. Diagonal Position Management

Position management is very trader specific. I can give you few guidelines but one will have to develop their own rules that are tuned to their temperment.

1. Before taking the trade decide on an initial stop loss. This can be either NF/NS level based or % loss based. The other alternative is to use a trading system that gives buy and sell signals and stick to those signals for exits too (as one closes and takes trade on the other side).

2. Don't over monitor the position. Keep key levels in mind and just take a look at the position probably once or twice a day. Even this is not required unless price is going fast against your position. The key thing to watch is the long strike price. If NF goes below long strike price, it is time to watch the position carefully as below the long strike price we start losing intrinsic value of the long position. Still, if short position has significant value left in it then that will act as a hedge.

3. As expiry nears it one will have to watch more carefully as gamma picks up for the short option and can result in big fluctuations if price is near the short strike.

4. Have a profit target in mind that is % profit based. 20-25% is usually the max profit for a diagonal (ITM long + OTM short type with steady volatility thru' the trade). Once profit reaches 15% start looking for a reason to get out on a further profit surge intraday. Don't push your luck in the last week before expiry, profit can swing wildly.

5. AVOID HOLDING THE DIAGONAL IN THE LAST THREE DAYS BEFORE EXPIRY. The profit/loss swings will be crazy due to high gamma of the short option. There can be sudden profit surges but a position can go quickly into loss too depending on where NF is at that time.

6. Avoid initiating a diagonal (that uses current month short) in the last 7-10 days before expiry. One may not get a good hedge so late. Going too much ITM for long to get a good hedge is not advisable as it decreases profit potential significantly.

7. Generally, if profit is 15% or more and only three days are left to expiry, consider closing the position.

8. If one wants to carry the position to next month, square off the short option and short the next month option that is OTM (with respect to the long option). This converts the position to a vertical spread. One will then be able to hold the position for another month.

9. There are many other adjustments possible but it is best to keep things simple. I will introduce other adjustments if necessary in the future via examples.

This concludes lessons on Diagonals. Questions are welcome. I will keep posting examples to make things clear.

[SwingTrader]

Examples of trading diagonals

Here is what I am planning to do. Instead of posting nicely selected examples which could be unrealistic, I will use a simple technical method to select bullish and bearish trades based on the signals and post examples based on the trade taken for each signal. This will give us all kinds of trades that would be more realistic and will give a good idea of what to expect if one is trading diagonals regularly. I will still have to use EOD data to keep things simple. For this backtest I will start the trades from Dec 2012 and take signals continuously, this should give us full one year.

The technical method is going to be a simple EMA crossover method with a twist on 60 mins NF chart.

*** DISCLAIMER : I AM USING THIS METHOD ONLY AS AN ILLUSTRATION. PLEASE DO YOUR HOMEWORK BEFORE USING THIS METHOD. ***



Chart Setup : EMA(13) and EMA(89) on 60 mins NF chart.

Buy Signal : EMA(13) crosses above EMA(89) and price then closes above nearest price pivot (daily closing basis). A continuation buy will trigger if price closes above any previous pivot and can be used to initiate a trade if one is not in an existing long trade.

Sell Signal : EMA (13) crosses below EMA(89) and price then closes below nearest price pivot (daily closing basis). A continuation sell will trigger if price closes below any previous pivot and can be used to initiate a trade if one is not in an existing short trade.

The only subjectivity is about the price pivot. I will still try and make the signals as clear as possible. For each signal I will : (a) Post a clear chart with the signal and the reason for taking it, (b) Select a diagonal based on the diagonal strikes selection guidelines (c) Post the P/L table for the diagonal.

Please let me know if there are any doubts about the method.

[SwingTrader]

[SwingTrader]

Starting my back test which will give me examples of diagonal trades to post here. Let us start with Nov 2012 expiry (29.11.2012). Since I am not in a trade I will look for the most recent ema crossover. It was a bullish crossover. So I will have to wait for a high pivot to break so I can take a long trade. Bullish crossover was on 27.11.2012. The high pivot to break was the one indicated on the chart, it was the 7th Nov high. NF closed above this high on 29th Nov. A trade could have been taken on this day just before close in the last hour. Let us say we take the trade on the next day at market close. Trade taken on 29th itself would have been much better though but we will take the trade next day to keep things interesting.



On 30th Nov NF closed at 5909.05. The combo that gives us the minimum required 30% hedge is this:

LONG NF JAN13 5700 CALL @ 282.85
SHORT NF DEC12 5900 CALL @ 87.45

The hedge % is 30.91%. The pricing is not that good as we had to select a diagonal that was completely ITM (long and short option strikes are below the NF price). This gives us more protection against down moves but restricts the profit too. Anyway, I have to take it as going deeper ITM does not make any sense and going slightly OTM will not give us the required minimum hedge. Here is how the position turned out:



Do note that NF closed lower than where it closed on the day the trade was initiated. The position profited even though the trade went sideways to down. The low profit was due to this and the fact that we could not take a ITM-OTM long-short diagonal. The one we took was completely ITM.

For the trade stats I will take the lowest profit from the last 3 days before expiry. The reason for this is my suggestion that one should close the trade at least 3 days before expiry. But it is left to the person taking this trade to decide. Profit/loss will fluctuate wildly in the last 3 days before expiry.

[SwingTrader]

A key point before I continue posting the backtest / examples:

The idea of posting these trades is not to show how well this strategy profits or how good these trades are. The important take from these posts should be the low risk idea of diagonals. Once the initial 4-5 days are over the risk in a properly priced diagonal goes down quickly. Even in the first 4-5 days the risk is lower than in a vertical spread. This idea is the focus of my strategy. Diagonals will never give you 100-200% return like an OTM option could. But it will also not destroy your trade if things go wrong which can happen very easily. This becomes very important when you are trading huge size. I will take 10-12% on average per month anytime as I understand it is huge in the long run. Any additional profit due to volatility movement will be a bonus.

The previous example was for the Dec 2012 trade. I will now move ahead and take each signal as and when it is triggered. Hopefully we get at least one trade each month.

[SwingTrader]

Trade no. 2

The last trade expired on 27th Dec 2012 (expiry day). We look for the next trade after that. The chart below shows that we had seen a probable sell signal but it did not trigger. NF did not close below the trigger (prior low pivot). We got an EMA crossover soon and then NF closed above prior high pivot on 1st Jan 2013 and we take the trade on this day at close.



NF closed at 6007.50 on this day. Here are the possible diagonals:

LONG NF FEB13 5900 CALL + SHORT JAN13 6100 CALL (Hedge % : 22.63%)

This is the standard ITM long + OTM short combo I begin with. But the hedge % is less, so I go more ITM...

LONG NF FEB13 5800 CALL + SHORT JAN13 6000 CALL (Hedge % : 32.11%)

This meets the required 30% hedge so I take this trade. This again, like last trade, is completely ITM diagonal. So one should be prepared for average profit of 10-12% in case of sideways move (15-18% or more if volatility explodes), 18-20% if price moves 100-200 pts from entry (25% or more if volatility too explodes).

Here is the P/L table for this trade:



I would exit around 3 days before expiry and we get around 13% which is about the right estimate for a ITM diagonal in a sideways move. Note that this too was a sideways range trade like the first trade as price did not close much higher than on trade entry date. If price had moved higher, we could have seen 18-20% profit.

While this trade is going on I would be looking all the time for a bearish signal. If triggered, the bullish would be closed and a bearish trade initialized. We saw a EMA crossover down on 25.01.2013 but price did not break the prior low pivot, so no bearish signal triggered before expiry on 31.01.2013.

We watch for either a high pivot break to initiate bullish trade (continuation signal) or a bearish signal to initiate bearish trade. First signal seen is taken.

[SwingTrader]

Trade no. 3

The previous trade got over at Jan expiry and we start looking for signals after that. We had seen a EMA crossover down on Jan 25th but the low pivot prior to that (on 17th Jan) did not break after the crossover negating the crossover. We got another crossover down on 31st followed again more clearly on 1st & 4th Feb. The low pivot in question (the one that had to break for a short signal) was was the 24th Jan low. It broke on 4th Feb when we got a daily close below this pivot. A short is initiated on this day.



Possible diagonals:

NF closed at 5996.30 on 04.02.2013. Here is the possible diagonal combos:

LONG NF MAR13 5900 PUT + SHORT NF FEB13 5700 PUT (Hedge %: 12.69%)
LONG NF MAR13 6000 PUT + SHORT NF FEB13 5800 PUT (Hedge %: 18.86%)
LONG NF MAR13 6100 PUT + SHORT NF FEB13 5900 PUT (Hedge %: 27.10%)
LONG NF MAR13 6200 PUT + SHORT NF FEB13 6000 PUT (Hedge %: 36.60%)

Now this is tricky. The 6100-5900 combo itself is totally ITM (almost 100 pts ITM). Going more deeper ITM than this means we will not profit much even though we get lot of protection against loss. So the choice is to accept slightly more risk and go for 27.10% hedge (6100-5900) or go for 6200-6000 which may give us max 10% profit. I would probably go for 6100-5900 and take slightly more risk knowing that it is still safe as the position will be 100 pts ITM. Let us check the P/L table for both the diagonal combos.

*** THIS KIND OF DIAGONAL PRICING IS USUALLY SEEN WHEN INDIAVIX IS DOWN TO VERY LOW LEVELS. IN JAN END - EARLY FEB VIX WAS BELOW 15. THIS MAKES OPTIONS VERY CHEAP. SINCE WE RELY ON DECENT OPTION PREMIUM FOR OUR SHORT OPTION WE SEE THE PRICING ISSUES AS ABOVE. IN SUCH CASES COMPROMISING SLIGHTLY ON HEDGE % IS FINE AS LONG AS THE POSITION IS ITM ***


P/L table for LONG NF MAR13 6100 PUT + SHORT NF FEB13 5900 PUT diagonal :



P/L table for LONG NF MAR13 6200 PUT + SHORT NF FEB13 6000 PUT diagonal :



The profit difference is significant based on which strikes are selected. The difference is more pronounced due to the low VIX levels.

[SwingTrader]

We can fix a trade that isn't working or is in the danger of going bad. This can be done through trade adjustment or another additional trade that balances out the current trade. This, of course, should be used as the last resort as there are downsides to every adjustment. Also, once the initial 4-5 days are over in the trade the risk goes down fast and is no need for adjustments. Even if you have to reverse the trade, any probable loss is going to be low.

DIAGONAL ADJUSTMENTS

1. Converting the trade to a ratio spread : Taking your trade example, we can short another option that is below the long strike price. It could either be same as the short strike or one strike higher. But this must be below the long strike price.

Pros : This adjustment provides additional hedge to the long. The max possible loss on the trade is drastically reduced if the trade continues to go against our original position.

Cons: Max possible loss if trade goes in favor of our original trade is now unlimited due to the extra short naked option. But the huge loss due to the naked option will come into picture only after your position first turns profitable. For us to take big loss, NF has to crash through both the short strikes and keep going down further. Before this happens the position will first turn profitable and then go into a loss. One will have to be prepared to close the extra hedge once NF reverses and starts going the favor of our original position. But that said, great risk is always there when naked short options are involved.

2. Converting the trade to a double diagonal : We can initiate an ITM call diagonal to counter the risk of our put diagonal. This is a low risk adjustment as this call diagonal will be a limited risk trade. But this adjustment will severely restrict the chance of a profit. One should be ready to square off this diagonal or the original put diagonal based on which side the trade is going. Only then will there be any chance of profit.

I am partial towards the 2nd adjustment - converting to double diagonal. The reason for this, of course, is the limited risk feature of this adjustment.