Calendar Straddle

The calendar straddle is one of the most complex options trading strategies, and involves four transactions. It's classified as a neutral strategy, because it can profit from a lack of short term price movement in a security. However, it's designed to also have the potential to profit from longer term volatility.

It's essentially a combination of two other trading strategies: the short straddle and the long straddle.  It's a good idea if you are familiar with those strategies before attempting to use this one. We have provided further details below.

Key Points

  • Neutral Strategy
  • Not Suitable for Beginners
  • Four Transactions (write calls/write puts /buy calls/buy puts)
  • Debit Spread (upfront cost)
  • Medium Trading Level Required

When to Use a Calendar Straddle

The calendar straddle has a very specific purpose. It should be used when you believe that the price of a security will stay within a tight range in the short term, but it will go through a period of volatility in the longer term. It's considered a neutral trading strategy, because it initially makes profit from the price of a security staying stable, but it can be converted into a long straddle: which is a volatile trading strategy.

There are better strategies to use if you are only concerned with profiting from a neutral outlook. This one is complicated, and it isn't one that should be used by beginners or inexperienced traders.

How to Use a Calendar Straddle

There are four transactions required to create a calendar straddle, and a combination of call options and puts are used. As we have stated, it's really two other spreads merged together (the short straddle and the long straddle), and you will really benefit if you already understand those two spreads.

The calendar straddle basically consists of a short straddle using a close expiration date and a long straddle using a later expiration date. The four transactions that are required are as follows.

  • Write at the money calls with a near term expiration date.
  • Write at the money puts with the same expiration date.
  • Buy at the money calls with a later expiration date.
  • Buy at the money puts with the same later expiration date.

The contracts should all have the same strike (equal to the current trading price of the underlying security) and you should use the same number of options in each transaction. Ideally you should carry out all four transactions at the same time.

Because the longer term contracts that you buy will be more expensive than the near term contracts that you write there will be an upfront cost required when creating this spread. There's no margin required though.

Below is an example of how you might use a calendar straddle, using hypothetical prices.

  • Company X stock is trading at $50, and you believe the price will stay around that level in the short term, but it could possibly breakout in either direction in the longer term.
  • At the money calls with a near term expiration date are trading at $2. You write 1 contract (100 options) for a credit of $200. This is Leg A
  • At the money puts with a near term expiration date are trading at $2. You write 1 contract for a further credit of $200. This is Leg B.
  • At the money calls with a longer term expiration date are trading at $4. You buy 1 contract at a cost of $400. This is Leg C.
  • At the money puts with a longer term expiration date are trading at $4. You buy 1 contract at a cost of $400. This is Leg D.
  • Your total credit is $400, while the total cost is $800. This results in a net debit of $400.

Potential Profits & Losses

The ideal scenario here is that the price of the underlying security doesn't move at all by the time the options written in Legs A and B expire. This would mean they expire at the money, and worthless. The ones bought in Legs C and D will also be at the money, but they will still have time value remaining.

The profit at this point is made because of the effects of time decay, and the fact that that near term options lose time value at a faster rate than longer term options. By the time the options written in Legs A and B expire, and assuming the underlying security hasn't moved in price, the combined value of the options bought in Legs C and D should be greater than the initial net debit.

The maximum profit you can make at this point depends on exactly how time decay has affected the price of the options written. You can theoretically forecast what this effect will be by using the Black Scholes Options Pricing Model, although you cannot necessarily rely on that to be 100% accurate.

You may also make a profit if the price of the underlying security has moved a little in either direction, but you will lose money if it moves substantially either up or down. The maximum loss is limited to the net debit, because any liabilities incurred from the written options will be covered by the owned options.

When the options in Legs A and B expire worthless, you have two choices about what to do. You could sell the options in Leg C and D, covering the cost of establishing the spread and making a profit. Your position would then be closed.

Alternatively, you can keep Legs C and D as open positions; you are now effectively left with a long straddle. If your original forecast was correct, and the underlying security is about to go through a period of volatility, then the long straddle has the potential for unlimited profits.

If at any time before the expiration date in Legs A and B, when you feel that the underlying security is about to move in price substantially, you can simply close those legs early (by buying the contracts back) and be left with the long straddle at that point.

Summary

The calendar straddle is a complex strategy, but it does have its uses in specific circumstances. It can return a profit from a period of price stability, and then be easily transformed into the long straddle if a period of volatility is expected to follow. The maximum loss is limited at any point, so the risks aren't too substantial.

The biggest disadvantage is the fact that there are four transactions involved, which can result in high commission costs. We wouldn't advise that beginners use this strategy, because there are more straightforward alternatives that would be more suitable.