Hey Rookie Bloggers! We have had some decent success on our mock trades recently as we demonstrated in the video last week. We will again look at the trades to see what has changed from last week until now. The markets are always moving and we need to be fluid as well. As Bruce Lee once said, “The stiffest tree is the most easily cracked but the bamboo or the willow bend with the wind!” This is how we must be as traders, we must remain supple and change when the conditions change. This doesn’t mean we just go all willy nilly but we build processes that allow us to move with the markets while still remaining inside our original parameters. This thought segues nicely into the trade we are going over this week. We are going to go over one of my favorite trades and we are going to talk about two separate ways to look at entering this trade. Of course, the theme of this blog has been the breakout to the trend phase and this trade fits nicely into this market condition.
The trade we are going through this week is the diagonal spread. The diagonal spread works very well when the market is trending because it can give a great balance of theta and delta, meaning we benefit from both time decay and directional movement. In addition to the two aforementioned greeks, there is one more that can sometimes work in our favor in a trending market. That is vega. Volatility can work both ways it can hurt or help trades depending on which type of trade you have on and what is happening with the other market conditions. Sometimes when markets are breaking out to the trend to the upside then volatility can actually fall and this may hurt certain trades. The opposite is true also if the market is breaking out the downside volatility can increase and actually help certain trades. There are many other factors affecting vega such as how close to earnings we are and the general fear in the market place and many other items such as news and economic events. I will endeavor to explain on each trade type how vega affects each trade.
The diagonal spread can be used in the breakout phase due to the characteristics inherent in the trade. The diagonal is used if there is an anticipation of a moderate move higher that will take some time to reach the target price. With the diagonal spread we are buying a long ATM option out in time, usually 2 months or more, and we are selling an OTM option in the nearer term. I like using around 4 months of time so that I have time to sell some premium and collect that sweet theta (time decay). The theta can be a buffer if one is wrong on the delta (direction). This does not mean you win on every diagonal trade you do, it just means that there is a back-up plan should the trade not go in your initial direction. There are a couple of ways that we can enter a diagonal. We can do both legs of the trade immediately upon entering the trade or one can leg into a trade like this from a long option play that may not be moving as fast as we would like. As we discussed in the long option play we need to be right on direction but also right on timing as theta is working against us. In the case of the diagonal, we can lessen this time decay effect and perhaps even put it in our favor depending on trade setup.
As I mentioned above the greek vega can be a help or a hindrance in this type of trade. If we initiate this trade when volatility is low then vega can build and bring more premium into our options without the aid of directional movement, thereby making our trade profitable even without the movement we desire. However, the reverse is also true, if we put this trade on when volatility is high and it drops then the trade can be hurt even if we get the directional move we wanted.
In this weeks video, I will go through the setup of this trade and show one that I already have on and we can see it play out as we go forward. We will also go over the rest of the mock trades to see if need to make some moves.
Happy Trading All!!!
Coach Holmes.
