Short Calendar Straddle
The short calendar straddle is quite a complicated options trading strategy, with four transactions required to establish the spread. As a volatile strategy it's designed to return a profit when a security moves significantly in price, regardless of in which direction.
It's really a spread that combines two other spreads (the long straddle and the short straddle). It will probably help you if you are familiar with those two spreads before you start using the short calendar straddle. Please read below for more details and when and how you can use this strategy.
The 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
When to Use a Short Calendar Straddle
The short calendar straddle should be used when you have a volatile outlook and you are expecting the price of a security to make a significant movement. This strategy will profit from a big price movement, regardless of the direction of the movement, so it's suitable for when you aren't sure about whether the price of a security will go up or down.
It will return a loss if the security doesn't move in price, or only moves a little, so you should only use it when you are particularly confident that there is going to be a substantial move. Calculating the exact potential profits, or losses, is quite difficult (we cover that in more detail below) so we don't recommend this strategy for beginner traders.
How to Use a Short Calendar Straddle
As already mentioned, the short calendar straddle is a combination of two other spreads. The idea is that you create a short straddle (which involves selling at the money calls and selling at the money puts) using a long term expiration date and to create a long straddle (which involves buying at the money calls and buying at the money puts) using a short term expiry date.
To summarize this, the following four transactions are required.
- Writing at the money calls with a long term expiration date.
- Writing at the money puts with the same long term expiration date.
- Buying at the money calls with a nearer term expiration date.
- Buying at the money puts with the same nearer term expiration date.
The same number of options should be used in each of the four transactions, and the strike should always be equal to the current trading price of the underlying security. The long term options that you write will be more expensive than the short term one that you buy, so you will be creating a credit spread and you will receive an upfront net credit.
We’ve provided an example below (using hypothetical options prices) to give you a clearer idea of how this works.
- Company X stock is trading at $50, and you believe the price will make a big move, but you are unsure in which direction.
- At the money calls with a long term expiration date are trading at $4. You write 1 contract (100 options) for a credit of $400.
- At the money puts with a long term expiration date are trading at $4. You write 1 contract for a further credit of $400.
- At the money calls with a near term expiration date are trading at $2. You buy 1 contract for a cost of $200.
- At the money puts with a near term expiration date are trading at $2. You buy 1 contract for a further cost of $200.
- You receive a total of $800 for the options written, and spend a total of $400 on buying options. This results in a net credit of $400.
Calculating Profit & Loss Potential
Calculating the potential profit and loss potential of the short calendar straddle is actually very difficult. This is because the strategy is based on how the price of options changes based on the effects of time decay and volatility. Although these changes can be theoretically measured by using an options pricing model (such as the Black Scholes Model), it's hard to make precise calculations.
However, the basic principle of how the short calendar straddle can return you a profit is a little more straightforward.
Because of the way it's established, you are completely hedged against directional movements. If the price of the security goes up, then the intrinsic value of the calls written will increase at roughly the same rate as the ones bought. If the price of the security goes down, then the intrinsic value of the puts written will increase at roughly the same rate as the ones bought.
The theory is that, if the price moves sufficiently, the extrinsic value of the options written will diminish at a faster rate than the options bought. Therefore, the ideal scenario is that the price of the security moves so much that the long term options and the short term options are roughly equal in price and you can close your position without any cost, and therefore retain the initial net credit as your profit.
The risk involved is that if the price of the security doesn't move much, or at all, the opposite will happen. The extrinsic value of the short term options bought will diminish at a faster rate than the long term options written. Therefore the worst case scenario is that the near term options expire worthless while the options you have written still have significant extrinsic value. To close the position, you would need to buy those options back and if that cost more than the initial net credit, then you would make a loss.
As you can see, the short calendar straddle is a complicated strategy with no clear calculations for determining whether you will make a profit and how much that profit will be. It's also difficult to work out exactly how much you might lose. It can be a useful strategy to use when you are expecting a significant movement in the price of a security, but you need to be fully aware of how the extrinsic value of options is affected by various factors.