TradeLogic – SKF Double Diagonal

This will be the first in a new series in which we will examine potential plays and follow them through in discussions attached to the post.

Hopefully it will be a good exercise in trading mechanics and help members to understand the goals of a trade, the logic of a trade and how to manage it through the process.  A double diagonal is an extended form of a butterfly spread in which you buy long puts and calls in a longer month than the short puts and calls you sell.  Our primary goal in this type of play is to gather premiums from our shorts, we are fairly neutral as to direction.

In yesterday’s (Sept 16th) market excitement, Chemistry said: "The premiums on SKF are so huge, there must be a quick play on that premium with opex so close."  That led us to decide to look at the following play:

We had been discussing the SKFs as covers since last Monday, when it opened at $97.30, to offset losses by concentrating on the ultra-short finanical ETF (the sector we thought was in most trouble) while the maket shook itself out but yesterday, right at 9:41 I said: "SKF – Well below the $140 line now, good protection that seems to have run its course for the moment."  During the day we kept watching different levels and we finished the day close to my lowest target ($115) that we were looking at from 11:07.

The above play came up at 1:35, ahead of the Fed where we expected a volatility crush on the short options so we wanted to find something that sold the most possible premium.  This trade puts $3,400 at risk and, since the longs are $125 puts and $135 calls, if the play runs out to January between those strikes, the January contracts expire worthless.

There are two schools of thought to managing a play like this: You can either leave the long side alone and keep rolling the short side to maximize premium (assuming you have a firm long-side target) or you can adjust the trade when advantageous.  The long contracts are simply placeholders that allow you to sell puts and calls but they also have a LOT of premium and we never like that.  This play was put up when the SKF was at $127 and we closed at $118.77.  That put the last sale of the Jan $125 puts at $29.50 and the Jan $135 calls slipped to $21.55 a total of $51.05 vs the $52.90 we started with. 

The September puts and calls netted out about the same as well and we’ll have to wait a bit to see how this one plays out.  If it heads lower, we are likely to roll the Sept $130 putter lower into more premium while we roll the Sept $130 caller to, for example, the Oct $110s for + $18 (assuming we are more bullish on the financials today).  That $18 would allow us to roll the Jan $135s down to the Jan $90s, last sold at $39.45.  A change like this locks us into a minimum value of $35 on our January spread (the difference between the two strikes), reducing our effective premium on the long side from $52.90 to $17.90 after just one day of trading. 

Since, in the above roll, both our caller and our putter are mostly premium and between our strikes, our management job is to simply keep moving them to strikes that keep them in the most premium possible (hopefully without adding cash), eventually working their way back to January (if we stay in that long) into a proper butterfly with very wide strikes.

We’ll see how this plays out, the SKFs are so volatile we don’t want to rush to make adjustments, only to take good opportunities if they come up.  The goal is going to be primarily to collect as much October premium as possible while widening the January strikes.

9/18 Update.  SKF was flying high at noon and had reached $146, so we looked at ways to take advantage of the volatility.  In comments I said (summarizing):  The $130 putter was wiped out, going from $10.30 on the 17th to $1.60 at the time.  Since that is more than an 80% gain, espectially on a volatile stock and a fairly long (Jan) put, that is a good time to make an adjustment.  Also, as the $130 caller was well in the money with little premium at $17.70, $10 could be spent to roll him to the $145s, which were almost all premium.  

It’s good to try not to put fresh money into a play like this as it is entered with limited risk and should stay that way.  The Jan $125 puts were "only" down $4 at the time but we attributed that to high volatility, not value as SKFs were at $146 and rising.  Since $8.90 was "won" from the $130 putter and the Oct $145 puts could be sold for $24, netting an additional $22+ in cash.  It can make sense to take that money and use it to roll the Jan $125 puts up to the Jan $165 puts while the roll was cheap.

The goal of this sort of butterfly is to widen the longer legs to improve the "win" zone, hopefully keeping the caller and putter in good premium between the strikes.  I also mentioned at the time that the trade need not be moved at all, since we had entered it expecting the wild volatility.  When trading in the SKFs resumed on Friday (9/19), I discussed the next adjustment, to this trade (whether it had been moved or left alone), which was to roll back down to Jan $130 puts (as the $165 puts were $81 and too far in the money) and to take advantage of the cheap call side (and high premium of the existing caller) by rolling down to the Jan $95 calls since that roll showed as just $9 (and still do).

Taking advantage of the rolls is key and there would have been justification for NOT rolling the Jan $165 puts down, leaving a $70 spread between the two January positions but it’s still better to do this without putting in fresh money and that was not going to happen.  Also note that the roll from the $165 calls to the $135 calls nets $26 (per last sale prices) while the $30 move to improve the call side costs $9.  If you keep spending $9 and getting back $26, that’s a nice bonus for rolling your position back and forth!

So no new money needed to be put into the trade (some would have been taken off the table) and the new end positions from either trade are as follows:

This is a bullish adjustment reflecting the huge dip in the SKFs, setting our Jan target back at $130 and our October target at $110, hoping the Federal aid package holds up until mid-October at least.  Since the first three positions are new and the $125 puts were the original cost but are now $44, that is about the profit in the trade so far ($18) as no new money came in.  In the more aggressive play, we would be $5 better off with the Jan $130 puts but let’s just track the one for simplicity’s sake.

The key to this position is that, after just 3 days, this play has elimintated the margin requirement (Jan puts and calls are now outside the calls that are sold against them), spread the Jan puts and calls apart – locking in $30 in value, and sold another $2,860 in premium.  That is not bad for a play that required $3,400 in capital to initiate.