EEM has been performing OK relative to the general market last week. My EEM diagonal call spread was working fine. The short
June 9 $42 call option that was sold
3 weeks ago for $0.27 was approaching its expiration date with 3 days left
from Tuesday, June 6. It was near the money as EEM price was around $41.72 and
Delta was around 0.46. The position had relatively high Gamma risk which could
turn the short call into a significant loss in a couple of days even though the
EEM price just increased a little bit to above $42. Therefore, I bought back the
short call for $0.10 to eliminate Gamma risk and to lock in a profit of $0.17 on the short call on Tuesday,
as I twitted in my StockTwits
message.

After that,
I have EEM long call January 19, 2018 $38 naked. Since it seemed to form a
small ascending triangle pattern with MACD turning up and travelling in the upper trending channel as shown in the chart below, I did not sell another
short call. I’ll short new calls when the stock movement provides the signal to
sell.

The option’s
Gamma risk could have a big impact on option strategies that include short options
when the expiration date is coming closer. This is because option Gamma
increases dramatically as the option approaches expiration, particularly for
options At-The-Money (ATM). Therefore, many option strategies that sells
options for protection and/or for benefit of time decay need to watch for Gamma
risks as the expiration comes closer. This and the definition of option Gamma
are very well explained in the article on
Understanding Gamma by Dough.com. I also had a study on the option Greeks in my previous post: A Summary of Effects of Prices, Time, Volatility on Option Greeks.

The diagonal
spread involves short options and therefore need to take Gamma risk into
account in its option adjustment rules. There are two major impacts on diagonal
spreads due to the characteristic of option Gamma. We already discussed the
first impact near the expiration. This results one short option closing rule
that it should be closed in the last week when the stock price is close to the
option’s strike price.

The second
Gamma impact on the diagonal spread is the possibility of Delta inversion. Since
the option closer to expiration has higher Gamma than that of the option that
is far from expiration, the Delta changes faster for the option closer to
expiration as well.

Thus, the
short option in a diagonal spread which is closer to the expiration may have
its Delta changing quicker than that of the long option which is farther away
from expiration. When the short option’s Delta exceeds the long option’s Delta,
it’s called a Delta Inversion. The wider the expiration dates of the short and
long options, the more frequently it’s likely to happen.

Delta
inversion causes originally bullish diagonal call spreads to lose money if the
stock prices continue to go up as expected. It also causes originally bearish
diagonal put spreads to lose money if the stock continues to fall.

For example,
a short call option may have a Delta of 0.50 while the long call option may
have a Delta of 0.70. As the short option gets closer to expiration and
near-the-money, its Gamma increases faster. If stock price increases $1, the
Delta of the short call option may increase faster to 0.75 while the Delta of
the long call option may increase slower to 0.72. So, the composite Delta of
the diagonal call spread changes from +0.20 (bullish) to -0.03 (0.72-0.75,
bearish). The originally bullish call diagonal spread starts to lose money if the
stock prices increase as the trader expects in the beginning of the diagonal trade.

Therefore,
diagonal spread management rules are required to avoid the Delta inversion in
order to trade the strategy profitably. What I’ve leant is that the short
option should be rolled when the composite Delta of a diagonal spread gets
closer to 0.15 area, or the short option’s Delta get above 0.60. If we roll up
or roll out the short call that is likely to cause Delta inversion, the
composite Delta gets expanded wider to have more profit room for stock price
increases. If the stock prices reverse direction from here, we can keep selling
new options as well.

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