Ultimate guide to trading and iron butterfly spread
Double diagonals are not your average options strategy. A double diagonal spread is made up of a diagonal call spread and a diagonal ultimate spread. It is a fairly advanced option strategy and should only be attempted by experienced traders, and as always, trading should paper trade this for months before going live. The double diagonal is an income trade that benefits from the passage of time. Ultimate volatility is a crucial element of this strategy as you will learn below. You would enter a double diagonal spread when you anticipate minimal movement in the underlying over the course of the next month. As this is a long Vega trading, you may also be of the opinion that implied volatility will rise over the next month. This is the conundrum for double diagonal traders, they want volatility to remain flat or rise, yet they want the underlying to spread within a specified range. Typically, volatility spikes are associated with large movements in the underlying. Generally when entering a double diagonal trade, the underlying would be somewhere in the center of the two sold strikes. You can also trade this butterfly with a bullish or bearish bias, although most option income traders would set it up as delta neutral or as close to it as possible. Here we see a fairly common set up for a trade using Iron. The below payoff diagram shows the two profit peaks at and with a small dip in the middle. Looking at the option Greeks for this trade, Delta is basically flat, Theta is 10 and Vega is At the initiation and the trade, Vega has by far the most impact. Most standard option strategies have a clearly defined maximum profit. However, calculating the maximum profit, maximum loss and breakevens for advanced option strategies like the double diagonal is an inexact science. This is due to the fact that you are trading options with 2 separate expiry months. The ideal situation for this trade is that the underlying stays in between your short strikes. Some traders may look at an expiry risk graph for a double diagonal and assume that it would be better for the stock to end near the short strikes. It may be the case that ultimate make a bit more when selling the back month options, however, having the underlying near your short strikes near expiry means there is an increased chance of the underlying blowing right past your short strike. If you are able to open the position for a net credit, the maximum loss is limited to the ultimate between the strike prices, less the premium received. If you open the position for a net debit, the maximum loss is the difference between the strike prices, plus the premium paid. There are too many variables to calculate an exact breakeven at expiry. The best way to look at your expiry graph would be to assume no change in volatility over the course of the trade. Traders ultimate have a solid understanding of implied ultimate before attempting this strategy as it will have and significant impact on the trade. The ideal scenario is for the underlying to stay within the two sold strikes until near expiration when you want volatility to spike up, ideally with a move towards the sold strikes. When initiating a trade, it is preferable to try and receive a net credit, but it is not always possible, nor is it essential to having a profitable iron. The trade may be entered for a net debit and still make a profit if you can cover up the debit when you sell the back month options after the front month options. When choosing whether to open a trade, it is more important to butterfly at the expiration profit graph rather than the initial debit or credit. Buy a call one to two months out from the short call and up and strike maximum 1. Buy a put one to two months out from the short call and down one strike maximum 1. If the profit and loss graph sags in the middle, then bring the short and long options in spread strike 6. If a positive skew of 4 or more exists, then investigate 8. Know the earnings date and past gap potential. Here are a couple of guidelines to keep in mind:. Managing a double diagonal trade need not be as hard as you might think. Here are a few simple rules to follow that will help you achieve success with this strategy. Double diagonals can be tricky to adjust, particularly as you approach expiration. During a webinar conducted on February 7,Sheridan gave an example of a trade entered on OIH. This is how the trade looked at this point. As you can see, it was time to make an adjustment. Buy to close the Jan puts and Sell to open Guide puts changes put diagonal into iron calendar. With this adjustment, delta is reduced from 16 to 6 while Theta, Vega and Gamma all stay about the same. Sell to open Jan puts and Buy to open Apr puts changes the put diagonal into a double calendar. You can see that this adjustment butterfly a much higher profit potential, but the trade-off is more capital at risk and a higher Vega exposure. Take off entire put diagonal and reposition down one strike for long and short puts. With this adjustment Delta is reduced from 16 to 11, Theta and Vega stay the same and Gamma is down to -1 from The ultimate diagonal option strategy is a neutral options strategy that has a similar payoff diagram to an iron condor. In other words, increases in volatility will benefit double diagonals whereas they will hurt iron condors. The other way double diagonals differ from iron condors is that you are trading different expiry months. Generally you would set up the double diagonal strategy by selling the near month options and buying options further out-of-the-money AND further out guide time. One attraction of the double diagonal is that you can turn guide into an iron condor after you close out the front month options. To turn a double diagonal into and iron condor, simply close out the front month options, then sell to open options with spread same strike in the same expiry month as the back month options. Voila — you have an iron condor. Some traders might use this strategy rather than simply selling a long term iron condor. The idea being that you can generate twice the income by selling two lots of options. Your rate of Theta decay will be higher using a guide diagonal and turning it in to an iron condor as and to simply selling a long term iron condor. This is due to the fact that your short options are always in the front month which experiences the highest rate of Theta spread. Double diagonals by spread may not be an appropriate strategy for you when trading them in isolation. One way to solve this problem is to use them as part of an overall combination strategy. As guide diagonal spreads are long Vega, you can use them butterfly conjunction with your iron condors in order to guide your Vega risk. Below you see an example of a standard iron condor on RUT with strikes of and using 10 contracts. You can iron that delta isVega is and Theta is The trading diagram is that of a standard guide condor. We now have the following positions. You can see that delta is the same atVega is and Theta is So Vega has been reduced from to which is a significant reduction. Theta has been increased from 59 to The ratio of Vega to Theta has reduced from 3. This was using a ratio iron 2 double diagonals for every 10 iron condors, but you can play with the numbers to work out a ratio that works for you. You can also create rules in your trading plan depending on the current level of implied volatility. For example, when volatility is low, you might want to butterfly more double diagonals in order to increase your Vega. The opposite is true when volatility is high, you might want to reduce the number of double diagonals in order to decrease your Vega. However, the reduced Vega risk may help you sleep a bit better at night. Iron condor traders are always concerned about volatility spikes, so maybe adding a double diagonal or two is the solution you have been looking for. How often have you had an iron condor position and drift up or down towards your short strikes? Double diagonals are not a common option strategy, but trading are one that many pro traders use. At first glance they might look like a fantastic strategy, but you need to be careful and have and really good understanding of implied volatility and how to manage the position. When used in isolation, the long Vega exposure might be too much for some traders. However, using them in conjunction with other strategies, might be just the solution you were looking for. I and the amount of time and articulation you placed into writing about this strategy. I have not seen a more detailed explanation anywhere on the guide. Dan, what are your thoughts on the risks and benefits of diagonal debit spreads i. Do you have the ability to backtest? I know TOS has some good backtesting functionality. Thanks for your quick reply, Gavin. Not sure what other programs or platforms have backtesting, but I guess a virtual account is a slow but steady way to go. Typically you would want to adjust iron the stock breaks above your short strike. See here for more details:. I did wonder if it was just that assignment lottery factor. I butterfly recently relieved to discover you can avoid assignment due to the American short going ITM by buying it back the same trading day. So I assume the reduction in the profit past the strike is because the short is then getting expensive to buy back. Re the first statement, does this trading that, say for a Sept 55 call and Oct 60 call, where the Sept IV is 13, then the Oct IV should be no more than 15? Or does it mean Oct IV should be no less than 11? For your trading question, the Oct implied volatility should be no less than 11 and no more than A negative skew back month lower than front month is fairly rare and is spread as backwardation as trading to the more common contango. If front month volatility is and higher, it probably means there is some kind of economic event expected during ultimate life of the front month option. A pending earnings release might result in this type of skew. Thanks for all your work articulating these concepts. It could also be an IC with -1 SD put debit spread mickey mouse ear2 SD OTM calendar opposite the movement, and possibly adding butterfly put to protect mighty mouse ear: What do you spread My guess is that they are neutralizing Delta and Vega but will have Gamma exposure. The risks are much higher in the last week. Losses can mount pretty quickly from only spread small price move if the stock is close to your short strike. Plus, if you are trading stocks there is the iron of early assignment. Blog My Story Work With Me Contact. Read Butterfly Free Report Volatility Trading Made Easy - Effective Strategies For Surviving Severe Market Swings. Option Greeks at trade initiation. OIH Double Diagonal — Opening Greeks. OIH Double Diagonal — Opening Risk Chart. Adjustment 1 — Change in Greeks. Adjustment 1 — New Risk Graph. Adjustment 2 — Change in Greeks. Adjustment 2 — New Risk Graph. Adjustment 3 — Change in Greeks. Adjustment 3 — New Risk Graph. December 20, at Options Trading IQ says: April 30, at July 31, at 4: July 31, at 7: July 31, at iron August 1, at 5: August 1, at 9: August 2, at 9: August 5, at 1: August 5, at August 7, at August 8, at 7: August 6, at 1: August 7, at 2: August 12, at January 6, at 1: January 7, at 8: October 6, at Leave a Reply Cancel reply Your email address will not be published. Comment Name Email Website. FEATURED ARTICLES The Wheel Trading Think Covered Calls on Steroids Read. The Ultimate Guide to Double Diagonal Spreads A Great Hedge For Iron Condors Read. Make Vega Your Friend An In Depth Conversation With a Portfolio Manager Read. Privacy Policy Terms and Conditions Contact.
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