We’re entering the following position for November expiration:
Day limit order
Buy to open 2 SPY Dec 137 calls
Sell to open 2 SPY Nov 133 calls
Buy to open 2 SPY Dec 119 puts
Sell to open 2 SPY Nov 125 puts
for a net debit of $0.15 or better.
Note that 2 contracts is our base position for double-diagonals. Trading whole-number multiples of the base-position size ensures that adjustments will not result in unbalanced positions. In addition, in order to come as close as possible to matching our Model Portfolio risk profile, it’s important to allocate equal risk to each initial opening trade in a cycle.
Also note that the strikes specified above are correct—we’re using an “unbalanced” double-diagonal to achieve the desired risk profile. For allocation purposes, this trade carries a risk of $6.15/share ($615 per contract) and for most retail traders requires $10.15/share in margin.
Analysis: Implied volatility dropped dramatically yesterday, but risk remains elevated so SPX/SPY IV probably will too (compared to the historical tendency to fluctuate between about 15% and 20%). Still, another collapse like yesterday’s would be a big challenge to recover from if we’re holding too much vega. That, in a nutshell, is why we’re continuing (for now, at least) to trade around one core double-diagonal position.
What’s different this month (besides the late entry) is that we’re compensating for volatility skew by shortening the distance between our call strikes. In effect, we’re making up for the relative lack of premium in the November OTM calls by reducing upside risk. (The maximum loss on the call side is $4.15, compared to $6.15 for the puts.) This gives us the risk profile shown below:
Perhaps more important, we’re starting out with very little delta bias and vega (both in proportion to capital at risk). Based on current implied volatility, the market is pricing in a 53% probability that this trade will be profitable at expiration. Our initial projected risk-management price thresholds are approximately SPY $124.50 and $133.25, although we’ll probably adjust for the bullish trend by opening a second position if SPY rallies to around $132.