Diagonal strategies during low volatility periods

We have received multiple questions about what option strategies we prefer to use when trading the signals from our systems.

While we also use simpler and common strategies like vertical spreads, butterflies, etc. some of the strategies we prefer fall under the category of diagonals.

First, let’s clarify the name. As you know, options are instruments that have a given maturity and at any given time there are multiple expiries that are available for trading. When combining multiple options all with the same expiry date but different strikes, we call that type of strategy “vertical”, while when we combine options from different expiries but same strike we call it “calendar”. A “diagonal” strategy is a mix of the two, because it is a strategy that uses different strikes on different expiries.

An example for the downside

One of the main strategy we use is the diagonal backspread. The term “backspread” is used to refer to strategies where the number of sold options on a given strike is lower than the number of options that are bought on a different strike. We need both options to be of the same type to make this a defined risk strategy. One example is a strategy where we sell one call with strike 100 and buy 2 calls with strike 120.

So a diagonal backspread involves 2 expiries and has a number of sold options that is lower than the number of options that are bought. Let’s jump into a real example to make it clear.

Let’s take the  EuroStoxx index options expiring in Aug 20 and Sept 17 2021, hence currently with 21 and 49 days left to expiry respectively.

The way we usually trade this strategy is on the downside as we treat them as bearish strategy with a hedge in case the underlying negates our signals and continues to rise.

By using one short call with delta 0.8 on the first expiry and two long calls delta 0.35 on the second expiry, the strategy is initially bearish with a delta of 0.1.

The plots below show the expected payoff of the strategy at the first expiry (in this case Aug 20). The plots also show the current P&L profile in blue and the current profile with shifted volatility in green (volatility is shocked down 15%) and violet (volatility is shocked up 15%). Please note: here the 15% shock is relative, so if current implied volatility is 10%, after a 15% shock it becomes 11.5%. In other words, if volatility is 10%, a 15% relative shock corresponds to 1.5% shock in terms of volatility points.

Areas where the green line is lower than the violet are areas where the strategy is vega positive. When these lines cross and invert, the sign of the vega exposure has shifted from positive to negative.

The larger the distance between the green and violet lines, the larger the vega exposure at that point. 

We have a max risk that is expected to be 250 EUR while our goal is a profit of 1,000 EUR if the markets declines as the models anticipate.

Not bad, but there is a very important clarification to make: why is this just an expected payoff? As of Aug 20, when the short call will expire, the remaining long calls will still be alive and today we can only estimate what their value will be at that time.

So this implies that the fantastic risk/reward you see on this strategy can be different by the time the short options expire. This is the single most important thing to understand about this type of strategies.

What can make it change then? Well, mostly implied volatilities. As you can see from the table above the charts, the strategy is vega positive. In this case we have a vega of 83 which means that our strategy could gain or lose 83 EUR for each 1% volatility point change (please note: 1% change is in terms of volatilty points, so for example when the implied volatility moves from 11% to 12%, that would be a 1% volatility point  change).

So our current estimated max loss is about 250 EUR but should implied volatility drop 2 volatility points, say from 11% to 9%, that would add a loss of 166 EUR to what we expected. Clearly, being vega positive, if the implied volatility increases by 2 points then also the whole payoff will lift by 166 EUR.

In the example above we have set up the strategy to have a negative delta of -0.1, given the 10 EUR multiplier of EuroStoxx options, this means that for each 1 point the index drops the strategy will have a 1 EUR profit.

If our models are more bearish, we can increase our negative delta by choosing a short call at a lower strike, hence even more in the money, as in the example below.

Or, alternatively, replicate the short deep in the money call with a deep out of the money put (at the same strike) and a short future position. In the example below, we use micro futures so 10 units would replicate the delta one of an option.

 

So why we like this strategy? We know that, as with any vega positive strategy, better to use them when implied volatilities are low and unlikely to drop much further. But this strategy has an expected payoff profile that is asymmetric and in favor of positive P&Ls.

If our models expect a drop in prices, the profit area is not difficult to reach and in case we were spectacularly wrong with our prediction, we could even end up profiting. As long as implied volatilities are low and not expected to drop further, this could prove an interesting strategy in the trader’s arsenal.

What if we want to reduce vega and give up to the upside potential in exchange for a higher payoff if the market goes in our direction? We could simply add a short call on the longer maturity (here Sept). The example is shown below.

While we have a higher profit on the downside, our hedge on the upside will start to become less effective after a +1% move.

 

An example for the upside

When implied volatilities are low and not expected to drop further, our favourite diagonal strategy for the upside is the one below.

There are many interesting points to note. Firts of all, in case our prediction was not correct, the strategy won’t experience large losses, at least until a 12% drop. In the meantime, volatility will likely rise and as you can see the green line crosses above the violet around the -3% point, so the strategy becomes vega negative after that point. In any case, it is advisable to close the position when the market has dropped between 3% and 5% because the positive vega and the likely increase in volatility (and don’t forget some help from theta) might help you to close at no loss or even at small profit. 

On the upside we also have the vega changing from positive to negative. If we started with a low implied volatilities, it is likely that the volatilities won’t drop much further if the underlying only moves few points up, so being vega positive should not hurt much. But should the market rise a lot it is possible to see some drop in implied volatilities and with our strategy shifting to negative vega, this should add profit to the payoff so it is advisable to close the strategy after such move without waiting expiration.

Trade management

The payoffs seen above are an expectation of the strategy’s P&L as of the first expiry. It is important to note that after that point, the portfolio will still have the options expiring in September so it is important to remember to manage them. They could either be closed or become part of a new strategy.

The directionality of these strategies can easily be adjusted by using the micro futures. It is advisable to replace a short deep in the money call with a short deep out of the money put plus short micro futures, as mentioned earlier. Not only there is the benefit of tigher bid/ask spreads on the out of the money options but the futures part can then be easily adjusted later on if we need to easily change the direction of the strategy.

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