Short Calendar Strangle

The short calendar strangle is one the more complex options trading strategies. The complexities come down to the fact that four transactions are required to create the spread and there are also difficulties in calculating exactly what the potential profits and losses might be.

This is a volatile trading strategy, so it's designed to be used when your expectation is that a security will move substantially in price. It's actually two other spreads combined into one (the short strangle and the long strangle),so it would be to your advantage to understand those strategies before using this one.

Details on exactly when you would use a calendar strangle, and how, can be found below.

Key Points

  • Volatile Strategy
  • Not Suitable for Beginners
  • Four Transactions (buy calls /write calls /buy puts /write puts)
  • Credit Spread (upfront credit received)
  • Medium Trading Level Required

Why Use a Short Calendar Strangle?

The short calendar strangle is very similar to another volatile options trading strategy: the short calendar straddle. Both are best used when you are expecting that a security is about to make a significant movement in price, but aren't clear on which direction that movement will be. The main difference between the two is that the short calendar strangle has lower margin requirements, because it uses out of the money options.

Therefore, the short calendar strangle would probably be a better choice if you didn't want to tie up capital in your brokerage account. You should note that you can lose money using this strategy if the price of the underlying security doesn't move much or if it stays stagnant. You should only really use it if you are confident that a big price movement is due to take place.

Creating a Short Calendar Strangle

If you are already familiar with the long strangle and the short strangle, then you will know that they require two transactions each. The long strangle involves buying out of the money calls and out of the money puts, while the short strangle involves writing out of the money calls and out of the money puts.

To create the short calendar strangle you combine these two other spreads, using a short term expiration date for the long strangle and a long term expiration date for the short strangle.  To clarify this, the four required transactions are as follows.

  • Write out of the money calls with a long term expiration date.
  • Write out of the money puts with the same long term expiration date.
  • Buy out of the money calls with a near term expirtion date.
  • Buy out the money puts with the same near term expiration date.

You will need to decide which strike prices to use, but you must make sure that all the options are an equal amount out of the money. We would advise using ones that are only just out of the money. You also need to be sure that you use the same number of options for each transaction.

Because the longer term contracts you write will be priced higher than the shorter term ones you buy.  You'll create a credit spread and receive a net credit at the time of applying this spread. Below is an example of how you might create a short calendar strangle.

  • Company X stock is trading at $50, and you believe the price will move substantially, but you are not sure in which direction.
  • Calls with a long term expiration date and a strike price of $51 are trading at $3. You write 1 contract of 100 options for a credit of $300.
  • Puts with the same long term expiration date and a strike price of $49 are trading at $3. You write 1 contract for an additional credit of $300 credit.
  • Calls with a short term expiration date and a strike price of $51 are trading at $1.50. You buy 1 contract at a cost of $150.
  • Puts with the same short term expiration date and a strike price of $49 are trading at $1.50. You buy 1 contract at a further cost of $150.
  • The short calendar strangle is created, and you have spent $300 and received $600. The total net credit is therefore $300.

Please note that we have used hypothetical options prices rather than real market date and we have ignored commission costs. This is purely to keep the example as simple and easy to understand as possible.

Calculating Profit & Loss Potential

The biggest drawback to the short calendar strangle is that there aren't really any precise calculations you can use to work out the profit and loss potential. This is because of the way the strategy is structured: to take advantage of the way options prices are affected by time decay and volatility.

We don't recommend this strategy for beginner options traders for this reason; you really need to have a very good understanding of the way the extrinsic value of options changes depending on different factors. Ideally, you should also be able to use a pricing model such as the Black Scholes model, because this can help you measure how the prices of options will move.

At the very least you need to understand the two basic principles behind the short calendar strangle: how it can make a profit and how it can make a loss.

The intrinsic value of the options is largely irrelevant, because you are completely hedged in that respect. The key is in how the extrinsic value changes based on the price of the underlying security and the time until expiration. Basically, if the price of the underlying security makes a significant enough move in either direction, then the extrinsic value will diminish and the price of the options will be made up primarily of intrinsic value.

The net credit you receive at the outset is because the extrinsic value of the options written is greater than the extrinsic value of the ones bought. If the extrinsic value of the options written moves closer to the extrinsic value of the ones bought, then you can close your position and make a profit.

If the price of the underlying security doesn't move much, or stays the same, then the effect is reversed and the shorter term options that you own will lose their extrinsic value at a faster rate as their expiration date approaches. This will mean that the difference between the extrinsic value of the options written and the options bought will increase, and the spread will move into a losing position.

Summary

The short calendar strangle does have its uses and isn't a trading strategy that should be ignored. It's certainly worth considering in a situation where you are expecting a security to move significantly in price but don’t know in which direction. However, there are better strategies to use if you would like to be able to precisely calculate break-even points and the potential for profit and loss.

As the short calendar strangle is one of the most complicated options trading strategies, we would suggest it should only be used by experienced traders.