Diagonal Spreads
Steve Lentz

What turbulent times we've seen in the markets! Wow. I think it's best to view it from the standpoint of a benefit to live and trade through unique period. Whether you were profitable or not, twenty years from now you'll all be able to say that you lived and traded during the crash of 2008. Someone will be impressed.

One of the results of this tumultuous activity is that options' implied volatility skews, both vertical and horizontal, have widened substantially. Now if you think the indexes have bottomed-out, and you want to place a bullish option spread, then you might be challenged to find good trades from a reward to risk standpoint. That's why the bullish diagonal spread might be a good choice.

An example from Apple Computer (AAPL) shows how vertical and horizontal skews create opportunity and pitfalls all at once. Let's pretend it's the close of October 13th, and we're feeling real bullish about the general market after a record day like this. We look around and find AAPL and decide to place a bullish spread trade. We play around in our OptionVue program and propose a far out-of-the-money bull put spread with the short strike positioned a full standard deviation away and below AAPL's multi-month low point. Figure 1 below is a screenshot from the AAPL matrix.

Figure 1: Horizontal and vertical volatility skews

Notice, in Figure 1 above, the sharp horizontal skew in the MIVs for November versus January, and also the vertical MIV skew going from out-of-the-money to in-the-money put options. Vertically, we see the Nov 60 puts have an MIV of 118% and the 120 puts are at 80.9%. Horizontally, we see the Nov 80 put is at a 103% MIV and the Jan 80 put is at 89.3%. Quite a difference.

Now, when we want to initiate a bullish spread position such as a Bull Put Spread proposed in the matrix, we are then trading against the skew. With this position, we are selling an option with an MIV of 103% and buying one with an MIV of 111%. This is not ideal, and the resulting Graphic Analysis screen in Figure 2 below shows a poor reward to risk ratio.

Figure 2 Bull Put Spread modeled at 20 days

If, in 20 days, AAPL hits our stop level at $80/share, we would lose 30% on our money. However, if AAPL rallies to $140/share, we would only make 12% on our money. Not good. Welcome to the world of trading against the skew.

Now let's contemplate a way to trade with the skew and take advantage of these MIV differences. In Figure 3 below, we're proposing a Bullish Diagonal Spread. Look carefully, and you'll see that with this position we are selling an option with a higher MIV than the one we're buying.

Figure 3 A Bullish Diagonal Put Spread can trade with the skew

It's important to also notice that this spread is placed for a net credit of $12. If AAPL rallies farther and both options expire worthless, we will at least make $12 and not lose money. The Graphic Analysis screen in Figure 4 paints a more detailed picture.

Figure 4 Diagonal Spread modeled at 20 days

With the Bullish Diagonal Spread, we would lose 7% on our money if AAPL hits our stop level at $80/share in 20 days. However, if AAPL rallies to $140/share, we would make 7%. This 1:1 reward to risk ratio is far better than with the Bull Put Spread, and is actually very, very good considering the trade has a 90% probability of profit.

Figure 5 Comparison of the Bull Put Spread with the Diagonal Spread

When the two spreads are superimposed at T+20, you can clearly see that the Diagonal Spread loses far less money if things don't work out and AAPL drops to $80/share. Yes, it's true that the vertical Bull Put Spread will make more yield if AAPL rallies to $130/share or more, but it's the reward to risk ratio discussed above that matters most.

In these times of rougher volatility waters, the Diagonal Spread is a strategy you should be aware of when looking for bullish trades.