The Basics of Double Calendar Spreads

07/04/2011 6:00 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

This complex option structure combines spreads at two different strike prices and is very similar to the double diagonal structure. See how these strategies work and how each is impacted by implied volatility.

Both “double calendars” and “double diagonals” have the same fundamental structure; each is short option contracts in nearby months and long option contracts in farther-out months in equal numbers.

As implied by the name, this complex spread is comprised of two different spreads. These time spreads (also known as horizontal spreads and calendar spreads) occur at two different strike prices. Each of the two individual spreads, in both the double calendar and the double diagonal, is constructed entirely of puts or calls. But either position can be constructed of puts, calls, or both puts and calls.

The structure for both double calendars and double diagonals thus consists of four different, two long and two short, options. These spreads are commonly traded as “long double calendars” and “long double diagonals” in which the long-term options in the spread (those with greater value) are purchased, and the short-term ones are sold.

The profit engine that drives both the long double calendar and the long double diagonal is the differential decay of extrinsic (time) premium between shorter-dated and longer-dated options.

The structural difference between double calendars and double diagonals is the placement of the long strikes. In the case of double calendars, the strikes of the short and long contracts are identical. In a double diagonal, the strikes of the long contracts are placed farther out of the money (OTM) than the short strikes.

So why should we complicate life with these two similar structures?

The reason each strategy exists is that they each give a trader different result in response to changes in implied volatility (IV), or in option “Greek" speak, the Vega of the position.

Both trades are Vega positive, Theta positive, and Delta neutral—presuming the price of the underlying lies between the two middle strike prices—over the range of profitability.

However, the double calendar positions, because of placement of the long strikes closer to at the money (ATM) responds favorably more rapidly to increases in IV, while the double diagonal responds more slowly.

Conversely, decreases in IV of the long positions impacts negatively double calendars more strongly than it does double diagonals.

You can learn more about examples of calendar spreads here.

By Dan Passarelli of MarketTaker.com

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