Getting Modestly Bullish On IWM

A 'Buy' Signal From A Technical Indicator Prompted A Trading Idea And Resulted In A Diagonal Spread

Having received a Stochastic 'buy' signal on April 13th, I took a look at a bullish trade on the Russell 2000 Small Cap index, using the IWM Exchange Traded Fund.

The buy signal alerted me into a potential trading opportunity.  What I saw was that IWM had a sustained upward trend, had pulled back to it's 50 day moving average, and that Stochastics was signaling a possible return to the trend.  Concerned about rising oil prices, I decided to get into a directional trade that was modestly bullish. 

A Buyer Or Seller Of Options?

Creating a bullish option position can be done through buying call options or, alternatively, selling put options.  Both can achieve our goal.  Assessing volatility helps in deciding which whether to be a net buyer or seller of options.

To assess volatility I took a look at the option chain for IWM, and found that implied volatility was about 17 on average.  April options were about to expire, the May contracts had about 30 days left, and the August options were the next available.  Anything beyond August provided more time than I would require.

The question is whether an IV of 17 makes for a cheap or expensive option.  To answer that question, I plotted a volatility cone or "Volcone" for IWM.  What it told me was that current IV was slightly below the mean, making these options relatively affordable.  All else being equal, I wanted to be a net buyer.

Having assessed implied volatility, I knew that I would be buying a call option.  The April contracts were expiring at the end of the week and the May only offered 30 days.  As such, August contracts were the ones I wanted to look at.

Adjusting Delta In Our Option Trade

Hoping to take advantage of a directional move, I wanted a rich delta profile for the trade.  This means that I do not want out-of-the-money contracts because they will carry delta of .30 or less.  To get a delta of .70 or more, I need to buy an in-the-money option.  That higher delta means that I will see a more responsive appreciation in my trade as IWM trades higher.

Hedging Against Time

I have now evaluated volatility and delta, so I now consider theta.  Because I am a net buyer of time value, my trade will lose value each day assuming all other things remain equal.  Also, my confidence in a big upward move in IWM is luke warm so I want to give myself more ways to win than just a directional move.

To offset theta decay, I am selling out-of-the-money May options to create a diagonal spread.  The spread will benefit from a directional move in IWM to the upside, an increase in implied volatility, and the passage of time.

The Diagonal Spread Trade

The trade was entered on Monday, April 17, 2006, and consists of the following:

BTO 2 IWM 72 Calls @ $5.40
STO 2 IWM 77 Calls @ $0.75
Net Debit $4.65

The risk graph provides a graphical depiction of the trade.  However, although profit is capped on the graph the ultimate return may be greater if we are able to roll the front month option into June and possibly July.  Each successive roll reduces the cost basis of the trade and moves the risk curve higher.

The maximum loss is limited to $930, but this trade will be closed prior to the maximum loss being incurred.  A video presentation of the trade design is available below.

IWM Option Trading Updates

• IWM Trade Update for May 18, 2006 | Diagonal Spread and Put Ratio Backspread
  
  IWM has tumbled in concert with the stock market the last two trading days, forcing a re-evaluation of our diagonal spread and put ratio backspread option trades.
• IWM Trade Update for May 2, 2006 | Diagonal Spread and Put Ratio Backspread
  
  Our IWM Diagonal Spread remains profitable. A put ratio backspread protects the downside risk without restricting this stock option trade's original profit potential. An update on our trading plan.
• Diagonal Spread Video
  
  A video walk through of how a simple Stochastic buy signal can result the construction of a diagonal spread on the Russell 2000 tracking stock.
• IWM Diagonal Spread Update
  
  The IWM diagonal spread is profitable. Consider adjusting this stock option position to reduce risk and enhance trading profits.
• IWM Put Ratio Backspread | Adjusting the Diagonal Spread
  
  The IWM diagonal spread turned profitable last week with a move in the underlying stock. We now open a put ratio backspread to reduce our risk and this option trade adjustment cost us nothing!

More Option Trading Resources

IWM Diagonal Spread Video
From trading idea to trade construction,
documented on video for your review.

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.