We all know how brutal the market has been to trade this year. We have had a hard push to the downside and large intra-day swings. With the sometimes daily swings and reversals, it is very hard to know which way to go.
Options traders have an edge in using price moves and volatility to their advantage, but lately, even options traders have had a tough time. Let’s first look at things that are not working well and why. With the steep and fast selloff since the first of the year, we have elevated volatility as measured by the $VIX. Over the last 5 years, we have become accustomed to a $VIX in the low teens, but since the first of this year, the $VIX has been trading much higher in the 20 to 25 or so range. The elevated $VIX is normally great for premium selling techniques such as Credit Spreads and Iron Condors, however with the wild swings, these trades may not be ideal in the current market conditions. It has been equally hard to buy or sell long options as volatility has pushed the prices higher and lowers the edge of this type of trade. Lastly, Calendars and Butterflys have not worked too well either, as they tend to work in tighter, range bound scenarios.
So what type trades are working in this market? One of the trades I have been using lately is the Diagonal trade. A Diagonal trade is a hybrid trade and although I am not sure why, it is not a common “go to” trade. The Diagonal spread can be used to take advantage of the current market environment.
So what makes the Diagonal Strategy different?
- Diagonals will allow you to “dial” the volatility or your trade up or down. How is that possible? By moving your strikes closer or wider on the initial set up you can actually raise or lower the “Vega’ of the trade which represents your Volatility exposure in the trade. This is fairly unique and again can allow you to really tweak the trade to suit your needs.
- The Diagonal trade can allow you to have little to no risk on one side of your trade. A Diagonal trade is a hybrid of a Calendar trade in that you have a front month option and a back month option. This structure will allow you typically have Calendar type structure, but more along the lines of the risk profile of a Credit Spread with one sided risk.
- You may able to enter the trade for a Credit. By using the Diagonal trade, we are selling premium in the front month and buying premium in the back month. In elevated volatility markets as we are in currently, in some cases you can sell more premium that you buy. This can give you a trade that starts with a Credit which is fairly unique and great way to start a trade.
- You may be able to end up with a long option for a very low cost. One great feature of the Diagonal trade is that over the life of the trade, if we are below our short strike at the expiration of the front month, we can let the front month option expire for full profit and leave the back month option alone. Once the front month option expires, this leaves us with a very low cost or sometimes “free” long option in the back month.
- It is possible to add on the “other” side and have an even wider trade. Option trade structures are very flexible and as the price moves around, the trades sometimes allows you to add on the “other” side to the trade. This means that if you started with a CALL diagonal, you can add on the PUT Diagonal or vice versa at little to no additional cost.
So, to sum it up, the Diagonal is a very flexible trade and is good to use for the current trading environment. Keep in mind that obviously no trade works all the time and that as you learn more about trading options, you will need to learn when to use different strategies in different market environments.
Do your homework first before you trade and don’t worry if you don’t understand Diagonals. Again, they are a hybrid trade and most people are not that familiar with them. If you want to learn more about Diagonals, there is a lot of good information on the internet or you can check out a recent class that I put together for that specific purpose.
If you’re a member, take a deeper dive into Diagonals with Bruce HERE.