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Stocks & Commodities V. 27:4 (34-41): A Flexible Strategy For Volatile Markets by John Manley


A Flexible Strategy
For Volatile Markets
Profit from option spreads on the S&P 500 by applying the 500 (SPY) through the exchange traded fund (ETF). Heres a

same tactic as you would playing chess. Heres how. breakdown and analysis of a real strategy.


The first part of this strategy was initiated on March 14, 2008.
ood chess players are always focusing on a At the time, the SPYs were in the process of testing the lows

G couple of moves in advance of the current one

being considered. They are peering out into the
future of possible opponent maneuvers and think-
ing of ways to counter them. We can apply the
same principle when were looking at how to profit (up,
made two months earlier in January 2008, around the 126
127 levels. (See Figure 1.)
At the time, the SPY had the potential to break support to
the downside because of the fear and confusion in the mar-
kets. If it did break support, I wanted to be able to profit from
down, and flat) with option spreads on the Standard & Poors that move. I had specific downside price targets based on
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 27:4 (34-41): A Flexible Strategy For Volatile Markets by John Manley
March 2008

Fibonacci extensions of the last 1.618 148.54

impulse move up. A break to the
downside would also support the
volatility (vega) component of
1.272 143.69
the spread and add to profitabil-
ity. Generally, falling prices sup-
port a rise in volatility.
On the other hand, the mar-
kets also reached extreme nega-
tive sentiment measures, tech-
nical support, and indicator di- 134.54
vergence, which could favor a 132.89
surprise snapback rally. With .618 131.24
that scenario, I wanted to find Initiate spread
.786 128.88
a way to profit as well. Taking
all of that into consideration, I
decided to start off with an 125.89
Swing low to high and 0.786 retrace
April/June put diagonal spread
on the SPY. 1.272 122.08
A put diagonal spread is a
1st target on breakdown
time spread that will buy fur-

ther-month options at one strike
and sell the same amount of op-
tions at a different strike in the FIGURE 1: PRICE CHART OF SPY. The SPYs were in the process of testing the lows made two months earlier in January
2008 around the 126127 levels.
front (closest) month. This al-
lows us to profit over a range of
prices over time, and the spread
can be morphed into other strat-
egies to take advantage of chang-
ing market conditions.
As with any trade, whether it SPY Strategy and
adjustments overlay
is a directional speculative play
1.618 148.54
or a defined-risk spread, strict
money management rules ap-
ply. If our stop-loss is hit, it is
necessary to shut the play down. 1.272 143.69
Here is the initial action. See Profit range - add call diagonal
strategy diagram (Figure 2): spread to put diagonal spread

BTO (buy to open) close trade

20 SPY June 124 puts
STO (sell to open) Profit range - original put 134.54
20 SPY April 129 puts diagonal strategy
SPY: 129.50 area .618 131.24
Net debit: 1,600 128.88
Max risk: 11,600
(spread + debit) 125.89
Profit range - morph down to
THREE PROFIT CENTERS double calendar spreads
1.272 122.08
One of the great aspects of this
versatile spread is that it has
three potential profit centers
versus just one for a directional
price trader and those profit FIGURE 2: PUT DIAGONAL SPREAD. The strategy is to buy 20 SPY June 124 puts and sell 20 SPY April 129 puts.
centers can cover a range of
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 27:4 (34-41): A Flexible Strategy For Volatile Markets by John Manley

Delta: 206.
Slightly bullish;
we are initially
synthetically long
206 shares, and
Put diagonal SPY Mar 14 this will diminish
as prices rise and
get longer as
prices fall
Theta: $60.
Working in our
Current price favor; dollar
amount deposited
FIGURE 3: PROFIT & LOSS DIAGRAM. Here you see that over time, there is a fairly large profit zone, with approximately a 4.8% to our account on
downside protection initially. If the SPY moves higher over time you will benefit and have decent profits and protection to the downside a daily basis. This
over time.
will change as
prices up and down. They are: price moves, time passes, and volatility changes
Delta (price movements) Vega: $172. Long volatility; will help on a fall in prices
and hurt profit to a certain degree on a rise in prices. I was
Theta (time value; we are positive theta meaning you
not expecting a complete volatility collapse in the mar-
are profiting daily as time moves forward)
ket environment, and delta/theta movements should
Vega (changes in the implied volatility of the option compensate for some volatility offset. Key relationships
legs. The put diagonal is long volatility, meaning a rise between front- and back-month vega and theta will be
in implied volatility will add profits to the position and affected by changes in volatility, which we will address:
a fall will hurt).
Initial lower breakeven (put diagonal) on expiry: 123.50
I was looking at this overall play as a possible three-part (-4.8% downside protection initially)
strategy with the idea of morphing the original play to the
Initial upper breakeven (put diagonal) on expiry: 146.00
downside and to the upside, should the technical picture
(12.6% upside breakeven).
support that. I wanted to let the market show its hand first.
As you can see from the P&L diagram in Figure 3, there is
PRICING a fairly large profit zone over time, with an approximate 4.8%
Three key greek (pricing components of options) interrela-
downside protection initially. You will benefit if the SPY
tionships are involved with this series of plays. One of the
moves higher over time and you have decent profits and
most important is the delta (price movement). As the market
protection to the downside over time.
begins to move around, we are going to monitor our position
delta and make adjustment decisions based on the constraints
I had set for the spread. A key characteristic of the put
Scenario 1: The markets break support and push lower
diagonal is that as prices fall, the delta gets larger, meaning
Heres how to make a couple of simple maneuvers to the
we are synthetically acquiring more shares with a price drop
existing spread and profit from lower price zones, should the
just the opposite of what we would want to happen. When
markets want to play there and extend your downside
prices rise, we are synthetically selling more shares short.
breakeven to more than 9% from current beaten-down prices.
Again, just the opposite of what we would like to see happen,
I initiated the strategy on Friday, March 14, 2008, with the
but that is the tradeoff for having positive theta (time value
put diagonal. By Monday, things were looking ugly for the
that is, deposits of eroding premium are credited to our
markets as emergency actions were taken over the weekend
brokerage account every day).
by the Federal Reserve to deal with the collapsing Bear
With option spreads there are a number of morphing,
Stearns. As a result, the Asian markets had sold off hard on
adjustment, and synthetic possibilities. The series presented
Sunday and by Monday morning the index futures in the US
here highlights just one of many prospects. The adjustments
were pointing to a big down day.
were chosen based on the markets technicals, volatility
As the market pushed to new lows on March 17, I modeled
readings, and passage of time during the selected period.
out morphing the original put diagonal into double calendar

Copyright (c) Technical Analysis Inc.

Stocks & Commodities V. 27:4 (34-41): A Flexible Strategy For Volatile Markets by John Manley

Strategy Comparison Payoff OPTIONS

15,000 Chess move one: Morph
into double calendars

shifts the entire profit zone lower, as

Profit or loss

the diagram in Figure 4 illustrates.
0 This move will decrease your po-
118.88 119.00 120.00 122.00 122.00 123.00 124.00 125.00 126.00 127.00 128.00 129.00 130.00 131.00 132.00 133.00 134.00 sition delta, making it much less sen-
-5,000 Breakeven shift from 123 to 118.50 sitive to price movements, increase
Original strategy
theta, meaning greater erosion of time
premium on a daily basis and thus
-15,000 deposits to your account, and in-
Underlying asset price
crease vega sensitivity to changes
FIGURE 4: MORPHING INTO DOUBLE CALENDAR SPREADS. You reverse the process by shorting April 124 puts and in volatility, which you can also
going long June 129 puts. This shifts the entire profit zone lower. hedge. The risk profile of the trade
(Figure 5) also changes because you
are adding a new position. With this
spreads (calendar spreads are time spreads also but with the model, your dollars at risk actually decrease by $600 with the
same strike prices in the front and back month). This move morphing to calendars.
will shift the strategy lower but still give a range of profitabil- In the comparison diagram in Figure 5, you can see that this
ity up and down the price spectrum. At the time, I was just strategy shift moves your initial lower breakeven down to the
testing the waters to see what the shift would look like. If the 118 area from 123, giving you almost another 7% protection
SPY took out the low and continued to press to the 124 area from the 126.55 area. It also expands your profit potential at
(our long strike), I would have begun the morphing process. these lower prices by a wide margin and still gives an upper
The model uses actual market prices and volatilities at the breakeven about 8% above current prices (around the 136
time it was created. With the selloff that day, the VIX was area).
spiking up. I had a feeling much of the volatility spike was This is the initial defensive move. If the market structure
being forced on the front-month options. I wanted to see if we really wanted to play at lower levels, you could add another
did have a volatility skew between the front and back month calendar series below the 124 level around 120. This
when morphing to double calendars. Sure enough, we did would give you a breakeven around the 114 area for April
about a 4% skew, making the initial adjustment that much more expiry. One of the caveats of these adjustments is how much
attractive. time has elapsed since the original strategy was put on. As we
The mechanics of a put diagonal morphed into double get closer to the April expiry, adjustments may have less
calendar spreads: Our original put diagonal starts off by effect as the premium is eroding. If enough time has gone by,
shorting the April 129 puts and buying the June 124 puts. To however, there is also a good chance that profits have built up
morph it into double calendars, you reverse the process by in the original strategy.
shorting April 124 puts and going long June 129 puts. This
Scenario 2: The SPYs
surge higher
Since establishing the
original spread, no ad-
justments have been nec-
essary. As of Wednes-
day, March 26, the origi-
nal put diagonal showed
Volatility skew on front an unrealized gain of
month options (April)
14.6% or $1,689 (see
Figure 6) over a 12-day
period (this snapshot was
Put diagonal morphed taken during market
into double calendar hours). The profits have
mostly come from the
erosion of time (theta)
and price movements
(delta). In that time,
prices have moved from
a low of 126.07 to a high
of 135.81. Prices were
FIGURE 5: CHANGE IN RISK PROFILE. The risk profile changes because you are adding a new position. With this model your dollars around the 133 area on
at risk actually decreases by $600 with the morphing to calendars. March 26, 2008. Re-
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 27:4 (34-41): A Flexible Strategy For Volatile Markets by John Manley

affects the other greeks

also. Because I was trav-
eling over the next two
days, I decided to shut
the play down for a re-
spectable return.
Technically, SPY had
March 26 update: unrealized gain found resistance at its
$1,689 or 14.6% over 12 days falling 50-day moving
average (MA). Should
it have the power to push
through the 50-day MA,
I would have looked at
establishing an April/
June call diagonal
spread to complement
FIGURE 6: PROFITS BUILDING UP. As of March 26, 2008, the original put diagonal was showing an unrealized gain of 14.6% or
$1,689.00 over a 12-day period. The profits have mostly come from the erosion of time (theta) and price movements (delta). In that the put spread, essen-
time, prices have moved from a low of 126.07 to a high of 135.81. tially creating a double
diagonal. This would
member, the SPY was around the 129.50 area when the shift profit to higher strikes and show a breakeven around 9%
strategy was initiated. above current prices (see the model in Figure 7).
Implied volatility has fallen since the original strategy was Here is the call diagonal spread I modeled at that time:
put on. The front month (short April 129 put) has seen its
STO (sell to open) 20 April 140 calls
implied volatility (IV) fall 4.1% (good), while the back
month (long June 124) has seen its IV fall 2% (bad). This BTO (buy to open) 20 June 143 calls
turns out to be a wash with respect to the overall fall in IV,
because the back-month vega is about twice the size of the By adding the call diagonal spread to the picture, it will
front month. The only benefit of falling implied volatility in once again decrease the delta (thus making you less sensitive
a spread like this (wed rather see IV rise) is that it will to price movement), increase theta (creating larger daily
accelerate time decay. premium erosion in your favor), and increase vega (a fall in
Implied volatility is also known as synthetic time. When IV implied volatility will hurt profits to a certain extent).
falls, time speeds up, and when it rises, time slows down. This The probability of profit has greatly increased, but you
have also increased your
dollars at risk with the
addition of the call di-
agonal. With respect to
volatility exposure,
there are a couple of
volatility hedging tech-
niques I use also, but
they are beyond the
scope of this article. The
amount of time you can
expect to remain in the
play is also a factor.

With a double diagonal
in place, you would
have unrealized profits
built in, a large profit
FIGURE 7: CALL DIAGONAL SPREAD. If the SPY pushed through the 50-day MA, I would have looked at establishing an April/June
range up and down the
call diagonal spread to complement the put spread essentially creating a double diagonal. This would shift profit to higher strikes and price spectrum for a
show a break even around 9% above current prices.

Copyright (c) Technical Analysis Inc.

Stocks & Commodities V. 27:4 (34-41): A Flexible Strategy For Volatile Markets by John Manley

short-term play, and the double diagonal could be morphed John Manley is a professional derivatives trader and man-
into other strategies to address changing market conditions ages a private derivatives-based hedge fund for a group of
going forward. high net worth individuals. The portfolio returned 28% in
You can continue to sell short strikes each month against 2008 and is up 100% since its inception a little over three
the back-month long premium and eventually morph the years ago. He also engages in advisory and educational
double diagonal into a short iron condor or even double services for individuals and ins titutions on the proper use of
butterflies (to change the IV outlook and use profits from exchange traded options for superior portfolio returns and
double diagonal to completely take the risk out of the morphed risk management. He holds the Derivatives Market Specialist
position). designation from the Canadian Securities Institute.
All in all, these strategy scenarios can be flexible, low-
stress ways to profit over a large price range with the passage
of time. S&C

Copyright (c) Technical Analysis Inc.

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