[Music] How do diagonals work? How do they work? We just did a couple of diagonals.
Tried to, um, let's take a look. Let's do it! Yeah, you get to see Austin Matthews.
That's good! That's good! Austin Matthews.
Yeah, I think he still plays for them. There's a couple of superstars, but yeah, I think, right, Pzi? I think you meant Puszi?
There's no Puszi! Um, diagonals are a directional strategy that has positive theta, and we use them when implied volatility is low. So we're showing you here this is a graph of the VIX, right?
So implied volatility right now is pretty much at or near yearly lows, right? Yes, yes, this is 2023, and we're definitely not at yearly highs. No, you know, we're a little bit higher than the lows, but not much, so we're right off yearly lows.
It's de minimus! We're right off yearly lows. Don't ever use the word de minimus if you're a Tasty Trader, ever, in front of me!
Um, and so the diagonal is an interesting strategy. Now, a diagonal is an interesting strategy because you can play it a hundred different ways. You can, like I did before, you can put the front month call below or put a collar below; you can put it above.
A diagonal just means you can set it up however you want, wherever you want the deltas to be—delta neutral, delta long, delta short. You know, you can make it aggressively long, aggressively short. There are all these different ways to trade it.
It's just a vertical spread embedded with a counter spread; that's all a diagonal is. So, let's take a look. A diagonal is constructed like a vertical spread, but it has the long option with a longer expiration date.
So the exposure of a diagonal is similar to a long vertical spread, but you carry positive theta, and you want volatility to expand. That's why you want positive theta. I mean, at least the way that we trade, we want positive theta, and we want to catch, you know, if you get a move where volatility expands, you want to make money from it in this case when it's really low.
So, how does the risk and reward change when the long strike of the diagonal changes expiration cycles? Let's take a look. We did a study from 2005 to present, so it's just a very long study.
Every time volatility gets cheap, we try to cover some different strategies that are solid in periods of low volatility. This is one of them. So, um, we're going to sell the 25 Delta put and 30 days to expiration and bought the at-the-money put at the following expirations.
These are kind of bearish plays: 30 DT, 60 DT, 75 DT, 90 DT. We manage when the short leg expires. There's a lot of different ways to do this.
A lot of times I like to sell the bigger front month put. Like, if we're buying, you know, in this case, if we were buying, let's just say we're buying the 30 Delta put, then I like to sell the 35 Delta put in the front month. Not this way; I like to do it the other way.
Make the position a little bit long delta. But it doesn't matter; it's all about the logic. It doesn't matter what strike you pick, but I'm just saying you can do anything.
But the mechanics of the trade all work the same. We compared the following trade statistics over time, and when there's a large drop in the market, we looked at the average P&L and the initial debit paid just to show you kind of like some of the statistics around diagonals. Because our argument with diagonals is they are low risk, low reward.
Let's go to the next slide with this particular position where you're short the 25 Delta put and long the at-the-money put. Now remember, this is from 2005 to 2023, which is a bull market. That's why we picked this because it's a bearish position in a bull market, okay?
With a good setup of low implied volatility, which you want in a diagonal. Yes, it's a bearish position in a bull market. Since 2005, on average, the longer diagonals have slightly larger delta exposure than a vertical spread because the delta of the longer-dated puts will not decay as fast as when the market goes against you.
So we looked at this, and we looked at the 30-day, 60-day, 75-day, and 90-day. You can see you pay more money, obviously, for longer, but the average P&L over time—all those numbers are negative because this is a bearish position. You're buying a deep, not deep—you're buying an at-the-money put and you're selling an out-of-the-money put.
It's a put vertical spread in a bull market; you're going to lose money. Let's go to the next slide. So these diagonals are all short delta and long vol volatility trades.
We generally only use these in low volatility. So let's take a look at the results in a period that started with the VIX at 15 and then rose to over 30, which is from November of 2021 to June of 2022, just to look at it in a case of rising volatility. Next slide!
So during that period, the 60-day diagonals with the 30 Delta short put outperformed significantly. You can see the difference. We just wanted to show you that if you're in the right volatility environment, these trades, um, have an average daily P&L.
This is just, again, this is a position where. . .
Volatility was low, but the market still performed nicely. However, even in a rising market, the right strategy is crucial because these positions all made money. The best duration of diagonals will depend on how fast the down move happens.
The shorter the selloff, the shorter duration you want the long option to be, but 60 days to expiration is a good middle ground. Sixty days to expiration is kind of what we did today. We did January.
How many days to expiration is January? Uh, January expiration has 63 days. There you go!
That's why we picked it—right on target! Let's go to the next slide. So, some of the takeaways: Diagonals are low-risk trades that combine a long volatility and a directional buy into one trade without much exposure to time decay.
Now again, you can get long or short; all you have to do is change that front month short option. If you're buying, you know, forget about the out-of-the-money put. If you're buying, let's say, an out-of-the-money put or an out-of-the-money call, either you make the short-term option lower or higher to adjust the Delta.
If you make it higher than the one that you're buying, Delta-wise, you're going to have a position that is very delta neutral. If you make it lower, you're going to have a very directional position. That's all it is.
We found in our study that the long put in a diagonal has a sweet spot of about 60 days. This provided exposure to spikes in volatility while maintaining the short delta exposure that will pay off if markets fall. Additionally, the 60-day expiration long put did not lose as much during bull markets compared to the long duration puts.
Again, I think the importance here is that, based on our research, we found that 60 days is the best. It gives you time to be right in a volatility environment that's not really suitable for selling premium. Yeah, it gave you the best chance to make money at the 60-day long strike.
I think that the other main takeaway is that over time—you know, again, we just showed you a very bearish position—but over time, if you do these things relatively delta neutral, they are going to have a positive P&L in low volatility. They're going to have a positive P&L, but it's going to be small risk, small reward. Very good, sir!
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