Calendar Strangles.

In my previous post, I wrote about how to make directional trades using options without worrying about time decay with Directional Calendar Spreads.

In this post, I will introduce you to the Calendar Strangle, a non directional play on volatility without worrying about time decay. This can also be called a Double Calendar Spread as it is made up of two Directional Calendar Spreads: one bullish using out of the money calls and one bearish using out of the money puts.

To set one up, first you have to look for an underlying with with an implied volatility that is low relative to it's yearly range. Implied volatility tends to be mean reverting, so if the volatility is low, there is a good chance that it will raise back to it's mean and beyond to the other extreme eventually. Usually between earnings announcements, a stock's implied volatility will be at it's lowest only to raise as the date of the announcement draws near.

Once you have your candidate, you will want to sell the nearby month's options. I would recommend you sell the calls with a delta of around 0.18 and the put with the -0.18 delta. And buy the call and put for a few months forward at the same strike prices as the corresponding option rights. This spread will be delta neutral when initiated, while having a positive vega and theta.

There are four things to watch out for in this spread. First, the bid-ask spread of each option in the strategy accumulates, so the bid ask spread becomes very wide. The best way to deal with this is to screen for underlying's with deep option markets and always use limit orders on the entire combination of options to try to get a price as close to the midpoint as possible.

Second, as the earnings announcement day draws ever nearer, the term structure of the implied volatility may work against you as the front month's implied volatility rises much faster than the later months. Ideally the front month of the spread should expire the day before the announcement. This is because at announcement, the underlying may move a lot and you may need to exit the spread having to buy back the front month at an inflated risk premium.

This brings us to the third issue. When the underlying price hits either of the strike prices, it is the time to exit. Ideally, this would happen as the front month expires for maximum profit. Price alerts must be placed to be ready to exit.

And the fourth and final issue is about the time between the expiration months. If you space the options with a small time difference, your required capital will be less and your return on it will be higher, if the trade is successful. The downside of this is that you'll have less time wait to achieve success. A longer time difference will give longer time to make turn a smaller profit. If the front month expires while the underlying is still between the strike prices, the spread can be reengaged by selling the new front month's options at the same strike prices.

My preference when using this strategy is to favor large ETFs with deep option markets. There will be less opportunities to find the right time in the implied volatility cycle, but in my experience the term structures are more stable then with earnings announcing equities.