Calendar Strangle

The calendar strangle is a complicated options trading strategy that should only really be used by experienced traders. It's basically a combination of two other strategies (the short strangle and the long strangle) that is designed to profit from the price of a security remaining very steady in the short term, while having the potential to profit from sizable price movements in the longer term.

Before attempting to use this strategy, you should already understand those two strategies and how they work. Please see below for additional details on the calendar strangle.

The Key Points

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

Why Use a Calendar Strangle?

The calendar strangle is designed to be used in a particular scenario, where you believe that the price of a security won't move much in the short term but is likely to move substantially in the longer term. This strategy returns a profit initially if the neutral outlook is correct, which is why it is considered a neutral trading strategy, but it can be easily transformed into a strategy that can profit from increased volatility.

If you simply want to try and profit from a neutral outlook, then there are other more suitable strategies you can use, but if you do expect some volatility in the long term, then this one should certainly be considered. As we have already mentioned, we don't recommend it for beginner traders though.

How to Create a Calendar Strangle

The calendar strangle is created by combining two other spreads: the short strangle and the long strangle. This means a total of four transactions, involving both puts and calls options. We should stress again that it's a very good idea to first be familiar with those two spreads before using the calendar strangle.

The particularly important aspect of the calendar strangle is that the short strangle should be created using a close expiration date while the long strangle should be created using a later expiration date. To make this clear, we have listed the four required transactions below.

  • Write out of the money calls with a near term expir\ation date.
  • Write out of the money puts with the same near term expiration date.
  • Buy out of the money calls with a later expiration date.
  • Buy out the money puts with the same later expiration date.

This will create a net debit (i.e. an upfront cost), because the contracts purchased will be more expensive than the contracts written due to the additional time value. The same strike should be used for the calls written and the calls purchased, and we would advise using a strike that is only just out of the money. The puts written and the puts purchased should use a strike that is an equal amount out of the money.

Below is an example of how you might establish a calendar strangle.

  • Company X stock is trading at $50, and you believe the price will stay at around $50 for a short period, and then possibly subsequently move substantially in either direction.
  • Calls with a near term expiration date and a strike of $51 are trading at $1.50. You write 1 contract (containing 100 options) for a credit of $150. This is Leg A.
  • Puts with the same near term expiration date and a strike of $49 are trading at $1.50. You write 1 contract for an additional $150 credit. This is Leg B.
  • Calls with a longer term expiration date and a strike of $51 are trading at $3. You buy 1 contract at a cost of $300. This is Leg C.
  • Puts with the same longer term expiration date and a strike of $49 are trading at $3. You buy 1 contract at a cost of $300. This is Leg D.
  • The net debit is $300 ($600 total cost of options less $300 total credit received).

Please note this example uses hypothetical options prices and ignores commission costs for the sake of simplicity.

Profit & Loss Potential

Assuming that the price of the underlying security does remain relatively stable, the options written in Legs A and B should expire worthless. The ones bought in Legs C and D will still have some time until expiration, and they will still hold some time value. As the rate of time decay is faster as options approach expiration, the options bought shouldn't have lost as much value as those written in Legs A and B, so at this point the strategy should be in profit. The options bought should be worth a total value that is higher than the net cost incurred when establishing the spread.

The actual amount of profit that you are likely to make in such a scenario is difficult to exactly calculate. You could use an options pricing model, such as the Black Scholes model, to theoretically forecast what the value of the options bought should be, but you cannot be completely confident that such a forecast will be entirely accurate.

In theory, though, you absolutely should be in profit providing the underlying security doesn't move in price, or only moves very little. If the underlying security does move substantially in price before the expiration date in Legs A and B, then your losses are limited to the initial investment made. Any liabilities in the options written will be offset by gains in the options owned.

If you are in profit at the point of the options written expiring, you are left with a decision to make about how to proceed at this stage. With the options written in Legs A and B expiring, you now just own the options bought in Legs C and D. You could sell them at this point, closing the position and returning a profit.

You could also choose to hold on to the options owned, because you now effectively have a long strangle position. If your initial prediction that the underlying security is likely to go through a period of volatility proves to be correct, then the long strangle can generate further profits for you.

It's worth pointing that, even prior to the expiration date in Legs A and B, if you feel the price of the underlying security is about to stage a breakout you can simply close Legs A and B and be left with the long strangle at that point.

Summary

The ability of the calendar strangle to profit from the price of a security staying steady coupled with the flexibility of easy transformation into the long strangle makes this a powerful strategy in the right circumstances. It's also subject to a maximum loss, so you know exactly what the risks are at the time of applying the strategy.

The main two disadvantages are the complexities involved and the amount of commissions you incur due to having to make four transactions.