Introduction To Calendar Straddle
The calendar straddle is a strategy that capitalises on low volatility in the underlying security. The strategy involves buying a long term straddle while selling a near term straddle. The whole idea here is to profit from time decay of the short term sold straddle. All options involved are derived from the same underlying security.
The calendar straddle is a limited profit and limited risk strategy.
Steps
2. Calendar Straddle : A Net Debit Trade
3. Perform economic, technical and fundamental analysis
4. Outlook : Low volatility in the short term
5. Study the option chain of the underlying security
6. Breakeven Analysis
7. Understand your profit zones
8. Limited loss
9. Capped profit
10. Calculate the risk and reward ratio
11. Intelligent Money Management
12. Setting Up A Calendar Straddle
13. Exit the straddle
14. Record your trade in a diary
15. Example Of A Calendar Straddle
2. Calendar Straddle : A Net Debit Trade
A calendar straddle will require a net debit as the long term straddle is more expensive than the short term straddle.
3. Perform economic, technical and fundamental analysis
The calendar straddle is best executed in a neutral market. If the markets are stagnant, a calendar straddle will yield a profit. More precisely, the price of the underlying security must trade between the upside and downside breakeven points. Perform economic analysis, fundamental analysis and technical analysis to ascertain the direction of the markets and the underlying security in question. Fundamentally, check that the price of the security is not going to improve or decrease very much on valuation concerns. For example, a beaten down value stock is projected to have a poor earnings per share results in the near term. Fundamental analysis can be done by screening potential candidates according to the criteria which you have set.
Technically, a trader should look out for this suggested chart patterns:
For more on technical analysis, fundamental analysis and economic analysis, please read :
Basic Economic Analysis , Basic fundamental Analysis and Introduction to technical analysis
The narrow the range of fluctuating prices, the better. Also, make sure that there will be no fundamental surprises such as positive or negative dividend announcements or a period where no major announcements is expected from the underlying security. In the case of options traded on a public listed company, it would be wise to read the annual reports and follow what the management has been saying.
4. Outlook : Low volatility in the short term
Once a trader has performed economic, technical and fundamental analysis, he should be convinced that the near term volatility is set to remain low. This will give him the conviction to execute a calendar straddle.
5. Study the option chain of the underlying security
Now, a trader should study the option chain of the candidates(underlying security) that he has identified. Pick the candidate with the smallest debit and the highest probability of earning a profit. Also, examine the strike prices of the options involved. The strike price, the price of the underlying security and the net debit will play a part in determining the breakeven points in a calendar straddle.
Read : Learn to read and understand options chain
6. Breakeven Analysis
Perform breakeven analysis with the use of software. Find out your breakeven points. Be mindful that the price of the underlying security must trade between the breakeven points in order for the trader to be profitable.
7. Understand your profit zones
After you have done breakeven analysis, you will be aware of your profit zones and zones of loss. The loss zones are to the extreme sides of the upside and downside breakeven points.
8. Limited loss
A calendar straddle has a limited loss profile. A loss occurs when the price of the underlying security moves significantly in either direction, up or down, during the remaining lifespan of the short straddle. When that happens, a maximum loss occurs when the options trader chooses to close out his trade. The maximum loss is equal to the initial debit of the trade. This is also the reason why it is important to seek out the smallest possible net debit. After calculating the maximum possible loss, this can be used to calculate the risk and reward ratio.
9. Capped profit
The profit of a calendar straddle is limited. The maximum profit that the calendar straddle offers is when the price of the underlying security trades at the exercise price of the sold options which form the near term straddle when it expires.
Once the near term straddle expires worthless, the options trader can choose to hold on to the long term straddle for a greater profit potential.
10. Calculate the risk and reward ratio
At this point after calculating the maximum potential profit and the maximum loss, a trader can calculate the risk and reward ratio. At this point, he may figure out that the trade may not be worth the risk that he is taking.
Read : Understanding Risk/Reward Ratio For Option Traders
11. Intelligent Money Management
If the risk and reward ratio is favorable, the trader will have to consider the size of the trading capital that he intends to allocate the the calendar straddle. This should be done wisely. As a rule, no more than 5% of the trading capital should be allocated to the trade.
Read : Intelligent money management strategies for option traders
12. Setting Up A Calendar Straddle
- Purchase a long term straddle
- Write a shorter term straddle
13. Exit the straddle
If the price has stagnated, the short straddle will expire worthless. Closing out the long straddle at the point when the short straddle expires worthless will yield the option trader a profit. The optiuon trader can also hold onto the long term straddle if he is of the view that the price of the underlying security is set to experience a spike in volatility. If the volatility is expected to stay low, the trader can choose to write another short term straddle to earn premium.
14. Record your trade in a diary
After you have exited the trade, record your trade in the diary and analyse your performance. Be honest with yourself and examine your mistakes and strengths. Over time, as you do this frequently, you will become a better trader.
15. Example Of A Calendar Straddle
It is February and the price of RRR Corp is trading at $50. An options trader sells a near term straddle and buys a long term straddle based on RRR Corp. To sell a near term straddle, the trader writes a March 50 put at $100 and a March 50 call at $100. To own a long term straddle, the options trader buys a June 50 put at $200 and a June 50 call at $200.
The net debit to the trade is thus:
$200 x 2 – $100 x 2 = $200
If the price of RRR trades at $50 on the expiration date of the March options, the sold straddle expires worthless while the long straddle can be liquidated at $150 for each option. Hence, the loss due to the long straddle is :
$200 x 2 – $150 x 2 = $100
The gain in the short straddle is :
$100 x 2 = $200
The net profit realisable when the trade is liquidated on the expiration date of the March options is thus:
$200 – $100 = $100
If the price of RRR Corp trades at $70 in March, the intrinsic value of the March call is worth $2000. The intrinsic value of the June call will also be worth $2000. As such loss on the March call is offset by the gain in the June call. As a result, the loss is limited to the net debit used to initiate the trade.
When the near term straddle expires worthless, it may make sense to write another near term straddle especially if the volatility of the underlying is expected to be low. This is done to collect premium when options expire worthless. However, if the trader expects the price of the underlying security to be more volatile than before, he may just hold onto the long straddle to profit from the increased volatility. An example is an upcoming earnings announcement where the trader expects analyst estimates to be beaten. An event like this will cause volatility to increase and hence, an opportunity for the options trader to profit from it.
If the volatility stays low till the expiry of the long straddle, the options trader will lose on the premiums paid for the long straddle. Hence, it is important to monitor the markets, the underlying security price and foresee any trigger events that will change volatility.
Read:
Uncovered straddle/Short straddle/Sell straddle