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The short calendar straddle is the inverse of the calendar straddle and is therefore employed in precisely the opposite circumstances: when the trader expects an immediate explosive move in the underlying, but is unsure which way it will go.
It’s a four-legged initiative that consists of a near-term long straddle and longer-term short straddle. Specifically, the trader buys one at-the-money call and one at-the-money put and sells a longer-dated at-the-money call and at-the-money put.
The trade is initiated for a credit, and the bigger the better, because the maximum gain on the short calendar straddle is limited to the initial premium garnered.
Early Closure – Always!
As you’ll see from the trading example below, the short calendar straddle possesses no benefit whatsoever to the trader past the expiry of the first (long) straddle, and should therefore be held no later than that date, to be sure. Under a best-case scenario, it should be closed at the same time the long straddle is closed, at a maximum distance from the strike price.
Here’s a chart of Praxair Inc. (NYSE: PX), maker of all things gassy, to help walk us through the short calendar straddle’s particulars.
In early June you catch wind of a massive South American expansion plan that could make or break Praxair stock.
News on several regulatory approvals is imminent, but no one is sure which way local government agencies will swing.
You take stock of the situation and figure a short calendar straddle is your best bet. You would prefer to buy a simple straddle, but the options are already fully priced, and unless there’s an enormous move in the stock, you could still end up with a loss.
You decide, instead, on a short calendar straddle, because that will lower the cost of the long position, even though it also limits the gains.
The Setup and the Move
On June 10, with the stock at exactly $122 (red circle), you reach into your pocket. You buy the August 122 call and 122 put, each for $4, and sell the September 122 call and 122 put, each for $5.50. Your total credit on the trade is $3.
Two weeks later the news hits: a conditional decline of regulatory approval that the company is permitted to appeal. It’s not an outright “No,” but it’s enough to start the ball rolling. The stock declines, gathering momentum into the long straddle expiry in August.
On that final day, with the shares crossing $109 (blue circle), you decide enough is enough. You close out the entire trade, and the numbers are as follows:
- Both call options are far out of the money and essentially worthless.
- The long put is trading for $13.20.
- The short put is trading for 14.20.
You leave the long call to expire and buy back the short call for $0.01.
You sell the long put and buy back the short put for a net debit of $1, and your full profit for the trade is $199 ([$3 – $1 – $0.01] x 100).
It’s not as much as the $500 you would have made with the straight long straddle ([$13 – $8] x 100), but there was far less risk.
Trading note: There’s nothing to be gained by holding the short straddle. Time is working against you once the long straddle is closed. Any consideration of leaving the short straddle in play past the closure of the long straddle should weigh the possibility of a theoretically unlimited, cataclysmic loss.
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