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How Does Short Calendar Strangle Work in Options Trading?

Short Calendar Strangle Risk Graph
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Short Calendar Strangle - Introduction

The Short Calendar Strangle is a volatile options strategy designed to profit when a stock is expected to stage a breakout in either direction.

The Short Calendar Strangle produces this effect by selling a long term Strangle while buying a short term Strangle. No matter which direction the stock breaks out, extrinsic value of all options involved would diminish as they go more and more in the money and out of the money. In this case, profit is made through the difference between the extrinsic value on the short long term options made and the loss of extrinsic value of the long short term options.

This tutorial shall cover how to use a short calendar Strangle as well as its advantages and disadvantages.

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Difference Between Short Calendar Straddle and Short Calendar Strangle

The Short Calendar Strangle is different from the Short Calendar Straddle in that Short Calendar Straddle uses long term and short term Straddles while the Short Calendar Strangle uses long term and short term Strangles.

The effect of this difference is that the Short Calendar Strangle would require a lot lesser margin to put on but would also have a much lower maximum profit potential and a higher maximum loss potential than maximum profit potential. Therefore, if margin is a concern, the Short Calendar Strangle would be a better choice than the Short Calendar Straddle.

When To Use Short Calendar Strangle?

One could use a Short Calendar Strangle when the underlying stock is expected to breakout strongly to upside or downside quickly while minimizing margin requirement.

How To Use Short Calendar Strangle?

Short Calendar Strangles simply consist of a near term long Strangle and a longer term short Strangle. This means writing longer term out of the money call and put options while buying the same amount of nearer term out of the money call and put options.

Buy Short Term OTM Call + Buy Short Term OTM Put + Short Long Term OTM Call + Short Long Term OTM Put

Short Calendar Strangle Example :

Assuming XYZ trading at $44. It is February and XYZ is awaiting an important court verdict in March.
Its Jun45Call is quoted at $1.10, its Jun43Put is quoted at $1.00, its Mar45Call is quoted at $0.75 and its Mar43Put is quoted at $0.70.
Sell To Open QQQQ Jun45Call, sell To Open QQQQ Jun43Put
Buy To Open QQQQ Mar45Call, buy To Open QQQQ Mar43Put

Net Effect: ($1.10 + $1.00) - ($0.75 + $0.70) = $0.65 net credit.

Profit Potential of Short Calendar Strangle:

The Short Calendar Strangle profits primarily from the diminished extrinsic value of the long term short options as they go in the money and out of the money as the stock breaks out. Intrinsic value losses are fully hedged by the short term long options, as such, the maximum profit of the short calendar Strangle is the difference between the extrinsic value of the long term options and short term options, which is the net credit received initially less residual extrinsic value.

Maximum loss occurs when the underlying stock remained stagnant and closed at the strike price of the options involved. When this happens, the short term long options expires worthless, losing more money than the long term options can compensate through time decay gains. The value of the long term options at expiration of the short term options can only be calculated using an options pricing model such as the Black-Scholes Model.

Profit Calculation of Short Calendar Strangle:

Maximum Profit = net credit - residual value

Short Calendar Strangle Example :

Assuming XYZ rallies to $64.
Its Jun45Call is quoted at $19.01, its Jun43Put is quoted at $0.01, its Mar45Call is quoted at $19.00 and its Mar44Put is quoted at $0.00.

Net Profit: $0.65 - (($19.01 + $0.01) - ($19.00 + $0.00)) = $0.63.

Short Calendar Strangle Example :

Assuming XYZ falls to $24.
Its Jun45Call is quoted at $0.01, its Jun43Put is quoted at $19.01, its Mar45Call is quoted at $0.00 and its Mar43Put is quoted at $19.00.

Net Profit: $0.65 - (($19.01 + $0.01) - ($19.00 + $0.00)) = $0.63.

As you can see from the examples above, the Short Calendar Strangle makes the same maximum profit no matter which direction the underlying stock breaks out.

Short Calendar Strangle Example :

Assuming XYZ remains stagnant at $44.
Its Jun45Call is quoted at $0.85, its Jun43Put is quoted at $0.75, its Mar45Call is quoted at $0.00 and its Mar43Put is quoted at $0.00.

Net loss = ($0.75 + $0.70) - ($2.10 - $1.60) = $0.95

Risk / Reward of Short Calendar Strangle:

Maximum Profit: Limited.

Maximum Loss: Limited.

Break Even Points (Profitable Range) of Calendar Strangle:

Breakeven points of Short Calendar Strangle can only be determined through the use of an options pricing model such as the Black-Scholes Model.

Advantages Of Short Calendar Strangle:

Lower margin requirement than Short Calendar Straddle.

Credit spread means no cash paid to put position on.

Disadvantages Of Short Calendar Strangle:

Higher maximum loss potential than maximum profit potential.

There are 4 legs to this trade which may require legging into the position in order to ensure or enhance profitability.

Alternate Actions for Short Calendar Strangle Before Expiration :

1. The moment the extrinsic value of the long and short term options are almost completely eroded due to a significant breakout, the position should be closed and profit taken. There is no need to hold til expiration because the engine that makes this options trading strategy work is the breakout, not time decay.

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Short Calendar Strangle