With the S&P down about 1/2% and the VIX up almost 2%, we’re opening the following position for September expiration:
Day limit order
Buy to open 2 SPY Oct 114 calls
Sell to open 2 SPY Sep 109 calls
Buy to open 2 SPY Oct 97 puts
Sell to open 2 SPY Sep 102 puts
for a net credit of $0.15 or better.
Note that 2 contracts per leg is our base position size for double-diagonals. Trading whole-number multiples of the base size ensures that adjustments will not result in unbalanced positions. Also note that matching our Model Portfolio risk profile requires a risk-based allocation strategy—i.e., risking an equal dollar amount on each initial position (prior to any adjustments).
Analysis: The most important aspect of this trade is limiting volatility risk. Our newsletter strategies are tied to volatility arbitrage, and we don’t want to buy implied volatility unless it’s relatively cheap—which certainly is not the case this afternoon. Could IV go up from here? Absolutely…but buying volatility at this point would be a hedging strategy, not an income strategy.
For our core income strategy, we’re entering as close to delta- and vega-neutral as possible, with short strikes wide enough to give us a generous profitability range and vertical spreads sufficient to take in a credit, and thus eliminate the possibility of taking a loss on a drop in IV alone (although that by no means rules out delta losses). The risk profile shown below projects a 56% probability of profit at expiration, with a relatively low base-position vega of 5.2:
Our price-level risk-management thresholds are at about $100.90 and $109.50. Given the right volatility conditions, we could hedge our delta to the upside with a calendar spread at around SPY $108.50.