A "Why We Love America" Option Trade
07/04/2012 7:00 am EST
In honor of the most important day on the US calendar, Dan Passarelli explains the mystique behind the double calendar spread.
What a country! Where else can you bet on the direction of a market and make money in either direction? Well, many worldwide exchanges actually, but on America’s independence day, let’s focus on a trade that’s as patriotic as American-style options: the double calendar spread!
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 (aka 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 each of both double calendars or 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- 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 OTM than the short strikes.
Why should I complicate my 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 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.
Happy Fourth of July to my American readers.
You can learn more about examples of calendar spreads here.
Dan Passarelli can be found at MarketTaker.com.