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"Most of the time, the front pays for these underpriced lottery tickets, so there’s no reason to part with them. Of course, this assumes you didn’t overpay for them in the first place or that we were 100% sure we sold something really expensive in the front. Anyhow, aim for anything with a delta below 10 in the back, and you’ll be just fine."

>> A sub-10 delta would be far, far OTM for the long leg, correct? If the short leg is closer to the money, would this not result in a return profile that can have extreme losses for large swings?

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You can but if you identified that the ATM money option is overpriced and prime for sell opportunities, it is very likely that the OTM in the same expiry are even more overpriced and eating in your edge.

The vol surface distortion tends to be lesser when you go further in time. In essence, I’m not saying you are not overpaying for insurance in the back month, I’m saying you are overpaying less. And in some instances when the market identifies clearly a problematic situation you may not be overpaying at all. In fact, if you apply this mostly in indices, you may consistently buy underpriced calls.

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Thank you for the detailed reply! This makes sense. So, does the suggestion to enter diagonal calendar trades in the current volatility/VVIX environment work better on puts than calls and indices (SPX/SPY/IWM/QQQ) compared to individual stocks?

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No, you should enter both sides equally - put and call, unless you have a clear edge on forecasting direction. I don't, personally.

In practice, calls are often underpriced and puts overpriced. But again, everything is relative: puts in the back month are still (usually) cheaper than puts in the front month. And calls are overall underpriced in indices but even more in the back month.

Then, markets are dynamic, so it is always best to check what the data are currently saying before applying everything blindly, particularly for individual stocks. That said, this formula tends to be quite effective in indices.

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A far OTM would not the silver bullet against losses. It will still hurt if things go down. But if they go down hard you will at least survive. If they go down hard enough and you have kept your OTM option, you even have a chance to make money out of it.

There is no free lunch, unfortunately - you will seriously improve your risk profile if you get closer to the money in the back. But you won't be able to keep them for a while because they are quite expensive.

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Sure! Also, why a diagonal calendar instead of doing something similar with far OTM puts/calls with the same expiry?

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