OPTIONS

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Trading With Dan Sheridan (Part 3)

Double Diagonals And Butterfly Spreads

by John A. Sarkett

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The third part of this series with trader Dan Sheridan looks at double diagonals with long, protective wings one or more months out from the short options, as well as the butterfly spread, an income-generating strategy.

Double diagonals are Dan Sheridan's single favorite strategy, and he likes to mix double diagonals in a portfolio with condors for diversification. Here's why: While increasing volatilities hurts the condors, it helps the diagonals. So one offsets the other. Let's look at double diagonals first.

DOUBLE DIAGONALS

In addition, the double diagonals strategy has a more favorable risk-reward ratio than other income strategies -- 1:2, 1:3, 1:4, compared with 1:10 for condors. The yields can reach 15% to 30% for 30 days on average.

Remember, this is a business -- "An insurance company without the overhead," as Sheridan says. Remember, he was a market maker for 22 years. Everything he does is hedged, quantified, managed, and managed in advance, "managed in times of peace, not in times of war," as he puts it.

Best option candidates for double diagonal strategy

• Stock is greater than $30
• Implied volatility (IV) in lowest two thirds of its two-year range
• Nontrenders, sideways movers
• Low volatilities (for nonmovers, we want to go sideways)
• Skews (volatilities near and far) in line, not more than four points apart
• Nonearnings months -- again, we don't want movement due to news
• Boring, sideways, predictable industries, no biotech startups or the like.

Filter

1.    Sell the call option strike (minimum 0.50 for short option) in the front month that is the first strike inside one standard deviation.
2.    Sell the put option strike (minimum 0.50 for short option) in the front month that is the first strike inside one standard deviation.
3.    Buy call one to two months out from short option and up one strike (maximum one and a half times the price of a short call).
4.    Buy put one to two months out from short option and down one strike (maximum one and a half times the price of a short option).
5.    If the profit/loss graph sags in the middle, then bring the short and long options in one strike.
6.    If a negative skew of greater than 2 exists (long month minus short month), then don't do the trade!
7.    If a positive skew of 4 or more exists, then investigate.
8.    Know the earnings date and past gap potential.

Case Study

Here's a double-diagonal example that Sheridan gave his option seminar session-goers. On October 13, 2006, with Whirlpool (WHR) at $88.83, Sheridan:

Sold 10 Nov 95 calls
Bought 10 Dec 100 calls

Sold 10 Nov 80 puts
Bought 10 Dec 75 puts

Credit: $0.73 or $730
Risk: $5,000

The plan

Dan Sheridan's strategy is:

1.    Adjustment target points were set at Whirlpool 81 and 94. This is where the risk curve showed losses gathering speed. If Whirlpool hits 81 or 94, roll the credits.
2.    When either credit can be taken off for less than 0.20, do it.
3.    When half of the initial cash flow can be closed out as profit, do it.
 

...Continued in the July issue of Technical Analysis of STOCKS & COMMODITIES

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