Options Trading - Diagonal Put Spreads Part 2
Leveraging a minimal amount of capital, mitigating risk and maximizing returns is paramount as the markets rotate out of the depths COVID-19 sell-off. Option trading offers the optimal balance between risk and reward while providing a margin of downside protection and a statistical edge. Proper portfolio construction and optimal risk management is essential when engaging in options trading as a means to drive portfolio performance. The Q4 2018 and the COVID-19 pandemic are prime examples of why maintaining liquidity, risk-defining trades, staggering options expiration dates, trading across a wide array of uncorrelated tickers, maximizing the number of trades, appropriate position allocation and selling options to collect premium income are keys to an effective long-term options strategy. A risk-defined diagonal put spread optimizes the risk management aspect of an option trade while maximizing return on investment.
Minimizing Risk and Maximizing Return:
Leveraging a minimal amount of capital and maximizing returns with risk-defined trades optimizes the risk-reward profile. Whether you have a small account or a large account, a defined risk (i.e. put spreads and diagonal spreads) strategy enables you to leverage a minimal amount of capital which opens the door to trading virtually any stock on the market regardless of share price such as Apple (AAPL), Amazon (AMZN), Chipotle (CMG), Facebook (FB), etc. Risk-defined options can easily yield double-digit realized gains over the course of a typical one month contract (Figures 1, 2 and 3).
Figure 1 – Average income per trade of $190, average return per trade of 7.3% and 95% premium capture over 41 trades in May and June
Figure 2 – Options win rate of 100% across 24 unique tickers using put spreads and diagonal spreads with an average length of each trade coming in at ~13 days
Figure 3 – Average return on investment (ROI) per trade of 7.3% using a risk defined strategy via leveraging a minimal amount of capital to maximize returns
An Effective Long-Term Options Strategy:
A slew of protective measures should be deployed if options are used as a means to drive portfolio results. One of the main pillars when building an options-based portfolio is maintaining a significant portion of cash on-hand. This cash position provides the ability to rapidly adapt when faced with extreme market conditions such as COVID-19 and Q4 2018 sell-offs. When selling options and running an options-based portfolio the following guidelines are essential (Figure 4):
Trade across a wide array of uncorrelated tickers
Maximize sector diversity
Spread option contracts over various expiration dates
Sell options in high implied volatility environments
Manage winning trades
Use defined-risk trades
Maintains a ~50% cash level
Maximize the number of trades so the probabilities play out to the expected outcomes
Continue to trade through all market environments
Appropriate position sizing/trade allocation
Figure 4 – A composite of ~80 tickers that can be used as a means to trade uncorrelated tickers across diverse sectors. This list can be downloaded Options Trading Ticker List that ties into the Trade Notification Service.
Basic Framework - Diagonal Put Spreads:
Options are a leveraged vehicle thus minimal amounts of capital can be deployed to generate outsized gains with predictable outcomes. A diagonal put credit spread strategy is an ideal way to balance risk and reward in options trading. This strategy involves selling a put option and buying a put option while collecting a credit in the process. When selling the put option, premium is collected and simultaneously using some of that premium income to buy a further dated put option at a lower strike price. The net result will be a credit on the two-leg pair trade with defined risk since the purchase of the put option serves as protection. By selling the put option, you agree to buy shares at the agreed upon price by the agreed upon expiration date. By buying the put option, you have the right to sell shares at the agreed upon price by the agreed upon expiration date. Thus risk is defined and capital requirements are minimal.
Risk is defined since you agree to buy shares at a specific price while also having the right to sell shares at a specific price. If a put option is sold at a strike price of $307.50 and another put option is purchased at a strike of $295 then the max loss is the strike width of $12.50 per share or $1,250 less the net premium received. Since the risk-defined approach has a max loss, the required capital is equivalent to the max loss. If the premium collected was $77 then the required capital would be $1,173 and at expiration of the contact an ROI of 6.5% is obtained for a winning trade (Figure 5).
If the underlying security moves against you and challenges the $307.50 strike then potential losses come into play. Since you have the right to sell shares at a $295 strike, the stock could go to zero and your losses would be capped at $1,175 since you’d be assigned shares at $307.50 and then turn around and sell the shares for $295 per share. The required capital is equal to the maximum loss while the maximum gain is equal to the net option premium income received. Only $1,173 of capital would be required to execute the trade in AAPL (Figure 5).
Figure 5 – Opening a diagonal put spread via selling a put and buying a put while taking in net premium income during the process. Capital requirement is equal to the strike width and risk is defined to maximize return on investment.
Potential Outcomes and Scenarios:
A normal put spread with the same expiration dates will expire together worthless with defined risk. If the option expires between the strikes then losses will incur and if the stock moves below your protection put then max losses will occur at expiration. In a black swan event, clusters of option trades can incur max losses and really jeopardize your profit/loss statement. My goal is limit the losses and not absorb any max losses to optimize risk management.
The further dated put protection leg in a diagonal put spread will allow you to sell-to-close the leg to extract value from the trade if it goes against you. If there's a week left in the further dated option then you still have time premium and if the stock really moves against you then you may have intrinsic value too to partially offset losses. The further dated put protection leg provides more tail end risk mitigation.
Sell a put strike @ $100 10JUL20 and buy a put strike @ $90 17JUL20 to net $100 in premium
A) If the stock stays above $100 at expiration the you net the $100 in premium AND you can sell-to-close the $90 strike for any remaining value to net more than $100 on the trade and capture more than 100% premium capture
B) If the stock trades below $99 then you begin losing money but the $90 strike gains in value and you can sell this $90 strike to offset losses since there's a week left in the contract due to time value. If the stock trades ~$98 at expiration then selling-to-close the further dated put protection will likely circumvent any loss on the trade.
C) If the stock trades below $90 then the $90 strike will gain in value penny for penny below $90 so you can sell this option to avoid any max losses and recapture value from the contract. You would buy-to-close the $100 strike leg to avoid assignment and then sell-to-close the further dated put leg with remaining time value to avoid any max loss situation.
Closing Diagonal Put Spreads:
Managing winning trades is essential so reversing the process via buying-to-close the option leg that was sold-to-open and then selling-to-close the put protection leg that was bought-to-open. This will allow you to close trades early in the option life cycle and capture value that was remaining in the put protection leg. A diagonal put spread was sold on SPY for a net premium credit of $370 and to close out the trade, I bought-to-close the $273 leg that I sold-to-open for a debit of $216.23 and I sold-to-close the $263 protection leg that I bought-to-open for $187.86 (Figure 6).
The net result was premium income of ($370 - (-216.23 + 187.86)) = $342 or an ROI of 6%. The income per contract was $56.90 while the max loss was $943 [($273 - $263) – Premium of $56.90 = $943)].
Figure 6 – Closing both option legs in a diagonal put spread after taking in $370 in premium income and closing the trade for a net debit of $28 to net $342 in income and a 6% ROI on the trade.
Options are a leveraged vehicle thus minimal amounts of capital can be deployed to generate outsized gains with predictable outcomes. A diagonal put credit spread strategy is an ideal way to balance risk and reward in options trading. The COVID-19 black swan event reinforces why appropriate risk management is essential while holding cash on-hand. The overall options-based portfolio strategy is to sell options which enable you to collect premium income in a high-probability manner while generating consistent income for steady portfolio appreciation despite market conditions. This options-based approach provides a margin of safety while mitigating drastic market moves and containing portfolio volatility.
Options trading is a long-term game that requires discipline, patience and time. The COVID-19 black swan event reinforces why keeping liquidity, spreading out expiration dates, maximizing sector exposure, maximizing ticker diversity, risk defining trades and continuing to sell options through all market conditions is essential. Continuing to stick to the fundamentals with defined risk trades via leveraging small amounts of capital to maximize profits is essential. Keeping a significant portion of your portfolio in cash is essential to the overall strategy. Diagonal put spreads offer superior risk mitigation in the event option trades challenge your protection legs.
Disclosure: The author holds shares in AAL, AAPL, AMC, AMZN, AXP, DIA, DIS, FB, GOOGL, HQY, JPM, KSS, MA, MSFT, QQQ, SPY, UPS and USO. However he may engage in options trading in any of the underlying securities. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of www.stockoptionsdad.com where options are a bet on where stocks won’t go, not where they will. Where high probability options trading for consistent income and risk mitigation thrives in both bull and bear markets. For more engaging, short duration options based content, visit stockoptionsdad’s YouTube channel.
Originally published in partnership with INO.com