IWM Diagonal Spread Trading Plan

May 2, 2006 - This Stock Option Trade Remains Profitable, Our Greeks Are Reviewed, and the Market Assessed. 

The share price of IWM continues to stay above the levels where we opened our diagonal spread, closing today at $76.29.  The debit for the combined diagonal spread and put ratio spread was $4.65 and the diagonal spread is now valued around $5.25, representing about a 12% to 13% unrealized profit.  It is time to assess the market and review the greeks of our stock option position.

IWM Trading As Anticipated

A review of the IWM stock price chart demonstrates that the stock has rebounded off of the 20 day moving average, which coincides with the lower standard deviation band.  There remains a fair bit of distance to be traveled between now and when we will meet the "finish line."  Although earnings continue to come in, IWM seems to be weathering the news without any significant moves to either the upside or downside. 

If IWM continues to trade as it has over the remaining time period, we should be well situated to roll our front month option.  That roll would need to be undertaken for a net credit, which will further reduce our risk in this trade and enhance our upside profit potential.

Assessing The Greeks For Our Combined Diagonal Spread and Put Ratio Backspread

Delta in the trade remains positive, which we would expect.  This means that as IWM trades higher, off of the 20 day moving average, we can expect to see our position increase in value. 

The short calls on the diagonal spread continue to have a higher rate of theta decay than our long August call options, while the long and short put options in our put ratio backspread essentially neutralize theta; keeping this trade theta positive.  A net positive theta means that our position will become more profitable as we approach the "finish line" or expiration date, assuming all other things remain static.

Gamma is negative, which reflects the fact our upside profit is limited.  Should IWM continue trading higher, the delta of the short call option will increase and begin offsetting delta gains in the long call option. 

The Vega for this trade is positive.  A positive vega means that our trade will benefit from increases in implied volatility.  The flip-side is that our position will suffer from any decrease in implied volatility. 

You will recall when this position was initially opened, we checked the IV levels against a Volcone and determined that we wanted to be net buyers of options and, thereby, go long volatility.  We have not seen an material increase or decrease in implied volatility since opening the position, but we should continue to keep our eye on volatility levels because they will effect the value of our long August call option and our ability to reap a fat credit when it comes time to roll the front month options.

Updating Our Stock Option Trading Plan

Our plan remains largely unchanged.  IWM is perfectly positioned.  If it stays in this price area we will do very well with this trade.  Things rarely remain the same, however.

If IWM trades lower, we will close out the trade at our pre-determined stop.  If the stock runs higher, we will assess our ability to roll to the next month.  The rules for rolling will be that we will roll to the same or higher strike.  We will not roll down.  We must be able to net a minimum credit of .50, but preferably .70 or better. 

If we cannot get our minimum credit the position will be closed for a profit.  Should our credit fall between .50 and .70, we'll exercise our judgment as to whether we want to roll or simply exit the position.

The put ratio backspread will most likely expire worthless.  It is most dangerous to us if IWM trades between the short and long strikes.  That backspread will be closed as part of the entire position at the predetermined stop.  Otherwise, it will be left open and allowed to expire worthless.

If we roll or front month options and stay in this option trade, we will evaluate whether we want additional downside protection.  By then we will be through the majority of earnings announcements, so we may simply use any additional credit to reduce our market risk.  If we are able to take in another .75 on the roll, our maximum risk would be reduced to $3.90 or about $780.  This will simply need to be something we take stock of when the time comes.

Good trading!

Additional Option Trading Resources

View Prior IWM Trade Updates
From trading idea, through option trade
construction, and all the updates along
the way!

Volcone Software
Should you be a buyer or seller?  It all
depends upon your assessment of IV.

Excel Option Calculator
See your option positions before you
open your trade.