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Calendar strangles are multi-legged, sophisticated propositions that aim to capitalize on a near-term lack of volatility followed by an explosive move in the underlying.
They’re a perfect strategy for periods leading into important earnings reports, where the outcome will be meaningful, but the approach to the report is expected to be sleepy.
Trade Composition
A calendar strangle is comprised of a near-term short strangle and a longer-term long straddle. Each straddle, of course, is composed of out-of-the-money calls and puts.
The trade is initiated for a net debit – and, in truth, it’s not the most opportune strategy for traders with a neutral outlook. Only when a longer-term breakout is expected should the strategy be considered.
Let’s look at a trading example to get a better understanding of the calendar strangle’s pluses and minuses.
This is a chart of conglomerate Canadian Pacific (NYSE: CP) for just over half a year:
The stock has been stuck in a tight range for months (red lines), and you believe it will continue as such until the legalities of a potential acquisition in early summer are made clearer.
The stock could go either way depending on the news, so you figure a strangle is the best way to play it. But what about the sideways drift in the meantime? Is there some way of pulling some cash out of that action, too?
After considering a number of options, you decide to sell a near-term strangle and buy a longer-dated one to take care of both eventualities and to lower the overall cost of the trade.
In late January, with the shares trading at $153, you jump in. You sell one April 145 put for $3 and one April 160 call for $3, for a credit of $6. You then go out to the July expiry and buy the 145 put for $8 and the 160 call for $8, for an overall net debit of $10 (8 + 8 – 3 – 3).
And bingo: the range-bound trade persists all the way through the April expiry, leaving the short strangle worthless and the long strangle open for any possible market-moving news.
Added Flexibility/Greater Risk
At this point a number of options are available to the calendar strangle player, and a thorough understanding of each is essential if unnecessary losses are to be avoided.
- Though it’s not relevant to the above example, had the stock moved significantly higher or lower before the short strangle expired, the trader would have done well to consider closing the trade altogether. Even though the short is “covered,” so to speak, by the longer-term position, much depends on the trader’s discipline. The short position possesses unlimited loss potential, and assuming any outcome but the worst is unwise in the extreme.
- After the initial expiry, if the trade is in a profitable position, closing the long strangle is also a possibility. Time decay acts more quickly on near-term options, so the long-term strangle may still possess considerable time value.
- Leave the long strangle open if the breakout hypothesis is still a possibility.
In the above example, the stock shot dramatically higher, closing at $195 by July expiry. The long put expired worthless, but the long call was $35 in the money ($195 – $160), offering a net gain of $2,500 on the trade ([$35 – $10] x 100).
Trader’s note: As mentioned above, honest calculations of break-even levels and maximum profits/losses are impossible to compute on calendar trades.
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