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Calendar Straddle

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					CALENDAR STRADDLE
The calendar straddle is implemented by selling a near term straddle while buying a longer term straddle with the intention to profit from the rapid time decay of the near term options sold. It is a limited profit, limited risk strategy entered by the options trader who thinks that the underlying stock price will experience very little volatility in the near term.
Calendar Straddle Construction

Sell Near-Term Straddle Buy Long-Term Straddle

LIMITED PROFIT POTENTIAL
Maximum gain for the calendar straddle is earned when the stock is trading at the strike price of the options sold on expiration of the near term straddle. At this price, both the written options expire worthless while the longer term straddle being held will suffer only a small loss due to time decay. Note that maximum profit is limited only on or before expiry of the near term straddle as the options trader has the option of holding on to the longer term straddle to switch to the long straddle strategy which has unlimited profit potential.

Calendar Straddle Payoff Diagram

LIMITED RISK
Maximum loss for the calendar straddle is limited and is incurred when the stock price had moved drastically in either direction on expiration of the near term straddle. At this price, both the near-term straddle sold and the long term straddle held will be almost equal in value. The options trader will typically sell the long term straddle to buy back the near term straddle and thus the maximum loss is equal to the initial debit taken to enter the trade.

EXAMPLE
In June, an options trader believes that XYZ stock trading at $40 is going to trade sideways over the next month or so. He enters a calendar straddle by buying an OCT 40 call for $200 and an OCT 40 put for $200 while simultaneously writing a JUL 40 call for $100 and a JUL 40 put for $100. The net investment required to implement the strategy is a debit of $200. On near-term option expiration in July, if the stock is still trading at $40, both the written options will expire worthless while the long call and the long put will still be worth $175 each due to a much slower time decay. Selling this long straddle will net $350 to produce an overall profit of $150 after factoring in the $200 initial debit taken. If instead, the price of XYZ stock had skyrocketed to $60 in July, the written near term straddle will be worth $2000 since the written put will expire worthless while the written call now has an intrinsic value of $2000. The long straddle will also be worth $2000 because while the put will be too far out-of-the-money to be worth anything, the long call will be very deep in-the-money and be worth $2000 (time value for the long call will be almost nothing since it is very deep in-the-money). As such, the options trader can sell the long straddle to offset the losses from the short straddle. Hence, his overall loss is the $200 from the initial debit taken to enter the trade.

FOLLOW-UP ACTION ON NEAR-TERM EXPIRATION
Like all calendar strategies, it is necessary to decide on which follow-up action to take when the near-term options expire. This decision depends heavily on the revised outlook of the underlying stock at that time. Should the options trader thinks that the underlying volatility will remain low, then he may wish to enter another calendar straddle by writing another near term straddle. If he thinks that the volatility is likely to increase significantly, he may wish to hold on to the long term straddle to profit from any large price movement that may occur. However, if the options trader is unsure of what to expect of the underlying, it may be best to take profit (or loss) and move on to evaluate other trading possibilities.


				
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posted:12/30/2008
language:English
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