Put Diagonal Backtest (Part 3)

Today I want to explore roll mechanics and discuss when might be the best time to roll in order to avoid LIVOC (defined here).

The put diagonal aims to collect upward market movement as sold intrinsic value. If we roll lower, then the goal is always to re-establish the high-water strike at some future point without ever incurring LIVOC.

When I started to study this strategy, I thought troubled waters arise for puts OTM at expiration.

I changed my mind in looking at the difference between option premium for ITM vs. OTM strikes. I realized when OTM, I don’t collect much credit when rolling up—certainly much less than the intrinsic value already lost:

From the bottom, $3.50 to $3.90 is an increase in $0.40 per five point change in strike price. Moving up: $0.60, $0.60, $0.75, $0.85, $0.90, $1.15, $1.50, $1.65, and $2.05 brings us to the 4245 ATM strike. Per five point increase in strike price, the options usually increase much less than half that amount.

ITM premium differentials tell a different story. Going from ATM upward in 5-point increments, we see premium differences of: $2.40, $2.70, $3.05, $3.55, $3.75, $3.90, $4.10, $4.65, $4.70…

I collect closest to $1/point on the roll when DITM, which made me think whether I do the roll with few or many DTE, the essential element is to roll when DITM.

This analysis, however, misses the separate contribution of EV. EV is almost nonexistent near expiration but farther out, it can be seen as [log]normally distributed around the current price. Let’s revisit the option chain with time premium instead of delta displayed in the fourth column:

Again, premium differences from one strike to the next are much greater for ITM options than OTM. These differences approach $5, but T.Prem (EV) makes up the difference when less. The $13.39 EV for the ATM strike may be considered a “head start” for premium differences less than $5 as we walk the chain higher. I won’t secure point-for-point value for most rolls, but EV will make up for the shortage.

My current theory is that regardless of when, I want to be sure to roll while the option is ITM (or DITM) in order to avoid LIVOC. The option prices deceive by making higher-delta rolls seem more efficient since premium differentials approach $5. Either way, though, I will have realized point-for-point value for market movement up to my sold strike in addition to any EV the option had at the time I sold anywhere on the chain at expiration when all EV has evaporated. Remaining ITM allows further gains as the market moves higher.

I will continue next time.