Double Calendar Spreads: Mechanics and Overview
Mar 28, 2018
Volatility traders often look to execute calendar spreads when they expect markets (or an underlying in particular) to be relatively tranquil in the near-term, and more volatile in the longer-term.
The reason this outlook is so suitable for a calendar spread is related to the position’s structure, which involves being short options in the near-term expiration, while simultaneously owning options in a longer-dated expiration. The name of this position is a “long calendar spread.”
An example of this in practice might include the following scenario: Imagine a trader notices an important election or referendum coming up on the calendar, which they expect will be a market-moving event. The trader additionally expects the lead-up period to the event to be relatively tranquil.
In this hypothetical scenario, a trader might choose to sell the expiration period prior to the event, while purchasing the expiration period which captures the event (i.e. a long calendar spread). The relative attractiveness of the spread would of course also be dependent on the two levels of implied volatility in the expiration months being considered.
Long calendar spreads are usually executed as net debit spreads - meaning the longer dated option is purchased, while the shorter-dated option is sold - which normally requires funds to be “debited” from your account. This is because the longer dated option will be more expensive than the shorter dated option.
As a reminder, a "calendar" or "time" spread always involves selling an option in one expiration month, and buying an option with the same strike price in a different expiration month. A calendar spread is executed with the same type of option (call or put) on both legs of the spread.
Long calendar spreads involve purchasing the later-dated expiration month, in favor of selling the shorter-dated calendar month (debit). Short calendar spreads involve selling the later-dated expiration month, in favor of purchasing the shorter-dated expiration month.
Short calendar spreads are executed more rarely in practice because they turn into naked options (i.e. magnified risk exposure) after the expiration of the near-term options.
Therefore, almost all of the information in this post relates to long calendar spreads - whether they be single or double (the latter will be covered shortly).
It should be noted that the same number of options contracts are traded on both legs of a calendar spread (1:1 ratio). Considering all of the above points, an example of a long calendar spread is shown below:
Long calendar spread: sell 100 XYZ 40 strike May calls, purchase 100 XYZ 40 strike July calls
Assuming a trader is considering a long calendar spread, there are traditionally two types of criteria used when filtering for such opportunities. The first is that a trader is expecting a particular underlying, or the market in general, to remain relatively tranquil during the expiration period of the short option (the nearer-term expiration).
This leg of the spread produces its maximum profit when the underlying expires exactly on the strike of the short option. The theoretical P/L of a calendar spread declines as the underlying moves farther and farther away from the short strike.
When searching for long calendar spread opportunities, traders also look for places in which implied volatility is higher in the shorter-dated expiration period, as compared to the longer-dated expiration period.
Obviously, the longer-dated option will cost more than the shorter-dated option (in terms of absolute premium) because of the extra time value in the longer dated option. However, as it relates to implied volatility in calendar spreads - it’s usually preferable to sell higher implied volatility, while purchasing lower implied volatility.
For long calendar spreads, the maximum loss is the net debit of the spread times the option multiplier (100) and the number of contracts traded. The maximum loss for short calendar spreads is theoretically unlimited due to the naked short premium exposure that can exist after the near-term options expire - a big reason why short calendars are executed more rarely.
Now that we've reviewed simple calendar spreads, we can move on and consider a slightly more complicated version, commonly referred to as "double calendar spreads."
Before jumping into the mechanics, it’s important to note that the general intent of a double calendar spread is very similar to a regular calendar spread. To deploy such a position, a trader would likely be expecting relative tranquility in the underlying over the near-term, and increasing volatility in the same underlying over the medium or longer-term.
A big difference is that the double calendar spread effectively increases the magnitude of the exposure on both legs of the spread.
Structurally, a double calendar spread involves turning your original single option spread (across two expiration periods) into a strangle or straddle (also across two expiration periods).
That means that a single calendar spread involves the deployment of a call OR a put in each expiration month, whereas a double calendar spread involves the deployment of a call AND a put in each expiration month.
Effectively, a double calendar spread, therefore, involves a straddle or strangle (one long and one short), deployed across two expiration months.
An example of a long double calendar spread is as follows:
Sell 10 XYZ May 40 strike calls
Sell 10 XYZ May 30 strike puts
Purchase 10 XYZ July 40 strike calls
Purchase 10 XYZ July 30 strike puts
As you can see from the above example, the structure of this position is effectively short the 30-40 strangle in May, versus being long the 30-40 strangle in July. Removing one of the strikes from both expiration months in this example would turn this position into a regular calendar spread.
As you might imagine, the addition of the second strike in both expiration months alters the profile of the theoretical P/L for double calendar spreads (as compared to single calendar spreads). However, the maximum loss remains the total amount paid for the spread.
The optimal outcome for a double calendar is for the short options to expire with the underlying right on the strike, or as close as possible. If you deploy a double calendar spread in strangle fashion, then the space between the strikes also represents a profit (though less than the endpoints).
Depicted below are the basic theoretical P/L profiles for a regular long calendar spread and a double long calendar spread (both theoretically traded delta neutral). These graphics should help you better understand the risk exposure represented by such trades:
Given the theoretical P/L profiles shown above, it’s evident these positions match a particular trading outlook.
Primarily, a trader deploying a double calendar spread would be expecting the underlying to remain within the range of strikes (strangle), or near the single strike (straddle), during the expiration period which encompasses the short options. Secondarily, the trader might also expect implied volatility to increase in the longer-dated options.
Given the dynamics of the financial markets, such conditions could present themselves at any time. However, there are two trading environments/situations that traders may want to specifically monitor for calendar spread opportunities.
During earnings season, implied volatility across different expiration months can become disjointed, possibly allowing for the deployment of such a position. This may occur before or after the actual earnings announcement. Make sure you understand and accept the risks associated with trading earnings prior to adding positions like these to your portfolio.
Recent volatility in the financial markets also reminds us that another set of conditions may present themselves which could make calendar spreads attractive.
For example, imagine that the VIX has spiked (as seen in early February 2018) and that implied volatility in the near-term has increased across the board. Next, consider that earnings season is on the horizon - maybe 1 or 2 months away.
In this case, a trader could hypothetically deploy a long calendar spread (single or double) which allows them to sell higher levels of near-term implied volatility which doesn't include earnings, in favor of purchasing longer-dated premium which does include earnings.
Obviously, an integral component of such a position is that one expects near-term volatility to decrease. If one expects choppy markets in the near-term, this structure becomes less attractive, even if the earnings months is "cheaper" from an absolute implied volatility standpoint.
If you do decide to deploy an earning’s related position, it’s important to confirm the date of an earnings release prior to trade execution - to ensure your long position does, in fact, capture the event.
Calendar spreads offer traders a great avenue for expressing a particular market opinion. If you decide that a double calendar spread fits your outlook and risk profile, most trading platforms should allow you to deploy all four legs of the spread simultaneously.
If you can’t deploy all four legs at once, it’s probably best to execute the spread in two legs - a call side calendar, and a put side calendar - which in sum will equate to the double calendar.
If you want to learn more about calendar spreads (single or double), we recommend reviewing the links below when your schedule allows. The third bullet point focuses specifically on calendar spreads and earnings:
If you have any outstanding questions about calendar spreads or any other trading related topic, don’t hesitate to reach out at firstname.lastname@example.org at any time.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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