Thursday, August 16th, at 1 pm, the Dow hit 12,517 intra-day. Friday, August 24th, the Dow closed at 13,378 – up 861 points in 6.5 trading sessions. In the same time period, the S&P 500 and NASDAQ are up over 7% and consistent as always, Happy Trading reports "We are 100% green on closed trades this week, on Wang’s World"
The volume was relatively low this week, particularly on Friday, which created a slightly negative divergence between rising price action and falling volume. While selling has abated and volatility has subsided, the number of new highs in the market and price-volume divergence are still reasons to remain cautious. This is a really challenging time for most traders as the lull of calm waters entices many to dive in with abandon. How can we be sure that this is not the calm before the next phase and more importantly, how can we profit in the market, irrespective of whether we are right or wrong?
One strategy that works very well in this market is the double-diagonal. We'll detail it in a few moments but before we do, let's take a moment to consider an approach that is somewhat similar in its end goal but disparate in implementation.
A strategy that many hedge funds almost consider "free-money" is shorting calls and puts out-of-the-money every month. In periods of relatively low volatility these options are consistent income generators, producing handsome rewards monthly since the options expire worthless more often than not. But then the day comes when volatility starts to spike, the market starts to correct, panic takes over and those short put options suffer from both the declining stock price and the soaring implied volatility. The effect can be catastrophic on an account and has been the cause of many a hedge fund's downfall! Yet, the same end-goal (profiting from short option premiums) can be achieved in a much safer way – the double diagonal.
Before highlighting the term double-diagonal, we'll first define the term "diagonal". A spread trade comprising options at different strike prices and different timeframes is considered a diagonal trade (if both options were at the same strike price but different timeframes, the trade would be considered a horizontal trade while a vertical trade comprises both options in the same expiration month but different strike prices). A diagonal trade may take the form of a calendar bull call (longer term long call with a shorter term short call at a higher strike price) or calendar bear put (a longer term long put with a shorter term short put at a lower strike price).
When we combine a calendar bull call and a calendar bear put we create a double-diagonal trade. Other combinations are possible that still yield a double-diagonal trade but for the purposes of this article let's assume we choose a double-diagonal involving a calendar bull call and a calendar bear put.
Trade Example
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Stock: New Oriental Education & Technology Group (EDU)
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Long Call Jan09 Strike $55 $13.50
- Short Call Oct Strike $60 Credit $1.65
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Long Put Jan09 Strike $50 $10.40
- Short Put Oct Strike $45 Credit $1.65
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Long Call Jan09 Strike $55 $13.50
[Note: In practice, a limit order would be entered to reduce the net debit of the trade since the bid-ask spread on the long options is relatively large in Jan09, $1.40 for the long call, $1.20 for the long put]
Now, no matter which way the stock moves, we have accounted for the trend. If the stock stays within the range specified by the short put and call strike prices, the short options will expire worthless and we can repeat the trade the next month. We can continue repeating until the short option premiums have paid off the long option premiums.
If the stock does make a big move, the short options can be rolled further out in time and out-of-the-money while the long options protect the short options against a massive directional movement. In order to make really big returns, Phil points out "the real trick (if you are trying to make more than 15%) is timing entries and exits and picking the right calls (and puts) to sell and deciding when to go naked into events. The LTP isn’t up 185% by ignoring it!"
Phil highlights these plays as he is making them in Comments daily. Some of our partners have outstanding results employing sophisticated hedging strategies so if you haven't had the privilege of learning how to trade by stepping in all the landmines yourself (like we did!) and you want to bypass those painful experiences then why not see for yourself how to traverse these uncertain times in a much smarter manner!
Trade Safely!
OptionSage
