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The long calendar straddle is a “layered” straddle strategy that profits from little volatility in the near term, followed by an explosive move later on. Layered means two straddles: a short near-term straddle and a long longer-term straddle.
The trade is therefore composed of four separate legs: the sale of one at-the-money call and one at-the-money put with the same expiry, and the purchase of one at-the-money call and one at-the-money put with a later expiry.
The strategy is most successful when the underlying closes exactly at the strike of the short straddle, leaving both options to expire worthless, then explodes higher or lower before the long straddle expires. As near-term options experience a faster rate of time decay than longer-term options, the opportunity for profits begins precisely upon expiry of the first straddle, when a great deal of the second straddle’s original price still remains.
Let’s have a look at a real-life trading example to better understand all the trade’s potentialities and considerations.
This is a chart of Pfizer (NYSE: PFE) for a full year:
In early May, your sources and research say that Pfizer shares are going to go into the deep freeze until the Food and Drug Administration decides on the viability of a new Parkinson’s drug in October.
You want to take advantage of both the potentially explosive news at the time of the regulatory decision and the period leading up to it, and your best thinking leads you to initiate a calendar straddle.
With Pfizer at $29 (red circle), like Batman you jump into action. You sell the Pfizer August 29 call and 29 put, as that’s the only available strike prior to the announcement. The former costs you $2.50; the latter $2.40. You then purchase the February 29 call and put: the first for $6, the second for $5.80. Your total debit on the initiative is, therefore, $6.90.
A Sideways Slide and High-Fly Ride
The shares trade in a rough band between $28 and $31 for the next three months, and Pfizer settles at $28.96 on expiry (blue circle). The short call expires worthless; the short put is $0.04 in the money. You buy it back with just a quarter hour to go before the deadline.
At that point, you have a long straddle in place to ride out the news that everyone has anticipated for months.
But you also have a choice to make.
Because the long straddle options are fetching $4.75 each, if you sell them now you can still make a nice profit. To be precise, a $256 profit ([$9.50 – $6.90 – $0.04] x 100).
It’s a tough decision, but you decide to close.
You take the $256, and in the end, you’re happy.
The stock moved strongly after the news broke, but only to $34.50 (black circle). Had you held, your long call would have netted you $5.50 – not enough to cover the initial cost of the trade.
Other Factors to Bear in Mind
Maximum loss on the trade is theoretically limited to the cost of establishing the position (in the above example, $6.90, as the long options cover any losses incurred by the short options).
Break-even is the strike price plus or minus the initial premium taken. In this case, $29 plus or minus $6.90.
Trading note: There are any number of strategies that profit from a low-volatility-now, high-volatility-later scenario, and each should be carefully considered in order to select the one that best comports to your trading outlook. However, the calendar straddle has the distinct advantage of requiring no margin to enact.
Best of luck!
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