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The short calendar strangle is a bet on volatility. It’s comprised of a near-term long strangle and a longer-term short strangle. It’s written for a net credit (the bigger the better) and relies heavily on that credit to produce a profit.
Experienced traders will recognize that the strategy is similar to a short calendar straddle, but it possesses the advantage of smaller margin requirements because the options written are out of the money.
Setting the Trade
Traders interested in using a short calendar strangle are expecting a very strong surge in price but are unsure of which direction it will ensue. They therefore buy a near-term call and put that are roughly equally out of the money and sell a longer-dated call and put with the same strikes as the first.
The initial credit received will have to be sizeable enough to offset the losses incurred by the short strangle once the underlying starts to trend strongly. If that can be achieved, the long strangle will be able to generate a healthy profit.
Below is a genuine trading example that will help us better appreciate the strategy’s specs.
This is a chart of J.C. Penney Co. (NYSE: JCP) for six months:
According to your research, after playing in the $7 range for a couple of months, J.C. Penney stock is expected to stage a breakout. No one is sure of the direction, but the move is expected to be significant, coming as it does on the heels of a highly anticipated earnings report.
With that in mind, you decide in late January to initiate a short calendar strangle (red circle). The stock is at $7.00 when you simultaneously buy the March 8 call and March 6 put, each for $2. You also sell the May 8 call and May 6 put, each for $5. Your total net credit on the trade is $6.
Timing Is Key
Should the underlying merely drift sideways at the outset of the trade , or move very little, the time value of the long strangle will quickly evaporate and put the trader in a dangerous position if the underlying begins trending strongly later in the trade. For that reason, it’s wiser to close all legs if nothing is happening and the near expiry is approaching, rather than leaving the longer strangle open to potentially catastrophic losses.
In the above example, the opposite occurs. The stock begins moving rapidly after the trade is set, soaring as high as $11.50 by the first expiry and putting the long call well into the money. The long put expires worthless, but the call fetches an additional $3.50, making for a total hoard of $9.50 through the first expiry.
The bad news is that the short call is also deep in the money, trading for $5.00, while the short put is going for $0.25.
Buying them both back is by far the wiser choice, as the chances that the stock will continue to trend higher are still strong – and you could end up losing everything you’ve gained to date.
You close up. Your gain in the end is a nice $425 ([$9.50 – $5.25] x 100) for just over two months’ work.
Note: Had you held the trade through the final expiry, the short strangle would have closed worthless and your profit would have more than doubled. But rolling the dice on such an outcome is never worth it.
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