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Double Calendar Spreads

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by Gavin in Blog
June 12, 2020 11 comments

Today we’re going to take a deep dive into the wonderful world of double calendar spreads.

We’ll look at how to set them up, when to use them, how to adjust them, the greeks and how they can be used in conjunction with other trades like an iron condor.

If you’re new to calendar spreads generally, you should read this article first.

Ok, let’s get started.

Contents

What Is A Double Calendar Spread?

A double calendar spread is an option trading strategy that involves selling near month calls and puts and buying future month calls and puts with the same strike price.

A double calendar has positive vega so it is best entered in a low volatility environment when the trader believes that volatility is likely to pick up shortly.

Double calendars have two profit peaks which are usually placed above (using calls) and below (using puts) the stock price.

This strategy performs well if the stock is trading near the peaks at expiration, but it doesn’t perform well if the stock gets into the peak too early.

Another good scenario for the trade is the stock staying flat, but volatility rising. In this case, the front month sold options will decay in price, but the back months will hold their value and not suffer too much from time decay.

As you can see below, the trade is in profit at the interim periods when the stock is flat. The lines below are T+0 (light green), T+14 (red) and T+28 (grey).

The image below comes from OptionNet Explorer. This is our example trade that we will use for this article:

MSFT Double Calendar Spread Example

Date: June 8th, 2020
Current Price: $187.20

Trade Set Up:

Sell 5 MSFT July 17th, 175 puts @ $2.41
Sell 5 MSFT July 17th, 200 calls @ $2.20
Buy 5 MSFT Sept 18th, 175 puts @ $6.12
Buy 5 MSFT Sept 18th, 200 calls @ $5.73

Premium: $ 3,620 Net Debit

Maximum Loss

While double calendar spreads might look complicated, the maximum loss is actually very easy to work out because it is limited to the amount of premium paid to enter the trade.

As this is a net debit trade, the most the trader can lose is the net debit. In this example that is equal to $3,620.

The maximum loss would only occur if the underlying stock makes a huge move up or down.

Looking at the zoomed out image below, MSFT would have to move to either 130-140 on the downside or 240-250 on the upside for the trade to experience the maximum loss.

That’s a move of 25.5% down or 28.2% up in 42 days.

Most traders would be able to cut losses well before that happened.


Maximum Gain

Like normal calendar spreads, it is impossible to know the maximum gain and the best we can do is estimate it.

This is because we don’t know what the value of the back-month options will be when the front month expires due to changes in implied volatility.

In out MSFT example, we can see that the maximum gain is estimated at around $1,050 at a price of $175 and $1,210 at $200.

This could be higher if implied volatility on the September options has risen, or it could be low if implied volatility has fallen.

Breakeven Price

Like the maximum gain, the exact breakeven price can’t actually be calculated but we can estimate it.

Looking the MSFT example, we can see that the breakeven points are estimated at $171.11 and $204.65.

Payoff Diagram

Double calendar spreads have a dual tent shaped payoff diagram with each profit zone centred over the strikes used in the trade.

If we were to place the strikes further away from the current price of the underlying it would result in a larger valley in the middle of the two peaks.

This example shows how a double calendar would looks if we used 160 and 210 as the strikes rather than 175 and 200.

Notice there is a large “valley of death” in the middle of the spread. This can be an ok setup if you think it is unlikely the stock will be trading in exactly the same place at expiration.

This sort of set up can also be a good way to hedge iron condors which do well when stocks stay neutral.

The other difference with this wider spread is that the trade costs a lot less. Around $2,000 in this case compared with $3,620 in the earlier example.

Instead of widening the double calendar, if we instead bring the strikes in a little closer to 180 and 195, we get another different looking trade with no valley of death at all.

In this case, it is much more of a neutral trade.

Risk of Early Assignment

There is always a risk of early assignment when having a short option position in an individual stock or ETF.

You can mitigate this risk by trading index options, but they are more expensive.

Usually early assignment only occurs on call options when there is an upcoming dividend payment. Traders will exercise the call in order to take ownership of the stock before the ex-date and receive the dividend.

Short puts can also be assigned early. The important thing to be aware of is that early assignment generally happens when a short option is in-the-money.

For this reason, I use puts for the lower calendar and calls for the upper calendar. That way the short options are likely to stay out-of-the-money which significantly decreases the chance of early assignment.

How Volatility Impacts The Trade

Calendar spreads are long vega trades, so generally speaking they benefit from rising volatility after the trade has been placed.

Vega is the greek that measures a position’s exposure to changes in implied volatility. If a position has negative vega overall, it will benefit from falling volatility.

If the position has positive vega, it will benefit from rising volatility. You can read more about implied volatility and vega in detail here.

Looking at our original MSFT example, the positions starts with vega of 158 which means that for every 1% rise in implied volatility, the position should gain $158.

The opposite is true if implied volatility drops – the position would lose around $158, all else being equal.

Changes in volatility can have a significant impact on double calendar spreads. Using OptionNet Explorer, we can see the change here assuming there is a 5% increase in implied volatility.

This is estimated of course and there are a lot of different factors that could impact the actual result, but it certainly illustrates that a rise in implied volatility is beneficial for the trade.

The opposite is true if volatility drops by 5%, we can see a sharp drop in the profitability of the trade.

For this reason, it is crucially important to have a very good understanding of implied volatility including term structure, and how changes can impact your trade.

How Time Decay Impacts The Trade

Just like regular calendar spreads, double calendars are positive theta trades meaning that they make money as time passes, all else being equal.

The short calls and puts experience faster time decay than the longer-term bought puts.

Overall, our MSFT double calendar has theta of 17 meaning that the trade should make $17 per day from time decay.

If for some reason the underling stock makes a big move and the trader fails to close out the trade, it actually becomes negative theta and starts to lose money through time decay. The red arrows below indicate where this occurs.

However, you should never let your trade get to this position and it should be adjusted or closed long before then.

Delta

Double calendars can be structured to be neutral, positive delta, or negative delta.

Our MSFT example starts with delta of +14 even though the strikes are placed almost an equal distance from the stock price.

Below you can see that by moving the strikes to 165 and 190 we have skewed the trade to the downside with negative delta.

This isn’t the normal setup, as most traders will place the strikes roughly an equal distance from the stock price, however it could certainly be traded this way if the trader had a significant bearish bias.

The same thing can be done on the upside if the trader has a strong bullish bias.

Gamma

Calendar spreads are negative gamma trades and that is also the case with the double calendar variety.

Generally, any trade that has a profit tent above the zero line will be negative gamma because they will benefit from stable prices.

Gamma is one of the lesser known greeks and usually, not as important as the others.

I say usually, in this post I explain why it can be really important to understand gamma risk.

Calendar spreads maintain a bit of a natural hedge because they are negative gamma, but positive vega.

The ideal scenario is that implied volatility rises (good for positive Vega) but realized volatility remains low (good for negative Gamma).

In other words, you want the stock to stay relatively flat, but show a rise in implied volatility (the expectation of future big price moves).

Just like with theta, if the stock makes a big move outside the profit tents, gamma can switch. In this case switching from negative to positive.

Risks

It goes without saying that as a range bound trade, we have a risk that the price of the underlying will rise or fall sharply causing an unrealized loss, or a realized loss if we close the trade.

Some other risks associated with double calendar spreads:

Assignment Risk

We talked about this already so won’t go into to much detail here and while this doesn’t happen often it can theoretically happen at any point during the trade.

The risk is most acute when a stock trades ex-dividend.

If the stock is trading well below the sold call, the risk of assignment is very low. E.g. a trader would generally not exercise his right to buy MSFT at $200 when MSFT is trading at $188 purely to receive a $0.50 dividend.

The risk is highest if the stock is trading ex-dividend and the short call is in the money.

One way to avoid assignment risk is to trade stocks that don’t pay dividends, or trade indexes that are European style and cannot be exercised early.

However, this should not be the primary factor when determining which underlying instrument to trade.

Otherwise, think about closing your trade before the ex-dividend date if one of the short options is close to being in-the-money.

Expiration Risk

Leading into expiration, if the stock is trading right around either the short options, the trader has expiration risk.

The risk here is that the trader might get assigned and then the stock makes an adverse movement before he has had a chance to cover the assignment.

In this case, the best way to avoid this risk is to simply close out the spread before expiry.

Volatility Risk

As mentioned on the section on the greeks, this is a positive vega strategy meaning the position benefits from a rise in implied volatility.

If volatility falls after trade initiation, the position will likely suffer losses.

The other risk with volatility relates to the volatility curve.

Generally speaking, when volatility rises or falls it has a similar impact across all expiration periods.

However, you could potentially run into a scenario where volatility in the front month rises (bad for the short options) and volatility in the back month drops (bad for the long options).

That would result in a double whammy for the trade.

That scenario may not be common but it could happen and it’s important that traders understand volatility term structure when placing trades that span different expiration periods.

Transaction Costs And Slippage

Double calendars are complex trades that involve four different option strikes.

There can be significant transaction costs and slippage when trading complex option strategies.

Remember that trades will need to be opened and closed and also potentially adjusted, so the transaction costs can add up quickly.

One way to solve some of that problem is by using a commission free broker.

Double Calendar vs Iron Condor

There are some similarities with double calendars vs iron condors in that they are both income based trades that profit from a stock remaining withing a specific range.

However, there are also some specific differences in that double calendars are positive vega and iron condors are negative vega.

Double calendars also have a profit tent at the short strikes whereas iron condors do better when the stock stays well away from the short strikes.

I actually like using double calendars as a way to protect the short strikes for my iron condors.

Another difference in a double calendar vs iron condor is that the bought options are at the same strike as the short options but in a future expiration period. An iron condor uses all 4 options in the same expiration period.

Iron Condor With Double Calendar

Double calendars can be a nice way to protect the short strikes of an iron condor by creating a profit zone around the short strikes.

Usually with an iron condor, traders don’t want the stock getting near the short strikes, but by adding a double calendar, we can help mitigate that risk.

Here we have a standard iron condor setup:

And here’s how it would look when we add in a calendar spread at each of the short strikes:

Notice that the delta hasn’t change but vega has change from -133 to +18 and theta has increased from 54 to 74. We have reduced our volatility risk and added to our time decay.

One downside is that there is now more capital required to enter the trade.

Double Calendar vs Double Diagonal

Double calendars and double diagonals are very similar. The only difference is that a double diagonal places the bought options further out-of the-money.

This has the effect of raising up the middle of the graph, but it can also mean the trade requires more capital as can be seen below. The double calendar is risking $3,620 whereas the double diagonal is risking $6,520.

Some other differences we can see from the above image is that the diagonal is closer to delta neutral, has lower vega and higher theta.

The maximum profit is fairly similar but the double diagonal does much better in the event of neutral prices.

Trade Management

Getting in to a trade is the easy part, how you manage the trade is much harder, but let’s look at some simple rules you can use to help you manage your double calendar trades.

As with all trading strategies, it’s important to plan out in advance exactly how you are going to manage the trade in any scenario.

What will you do if the stock rallies? What about if it drops? Where will you take profits? Where and how will you adjust? When will you get stopped out?

Lots to consider here but let’s look at some of the basics of how to manage double calendar spreads.

Profit Target

First and foremost, it’s important to have a profit target.

That might be 30% of the capital being risked in the trade or you may plan on holding to expiration provided the stock stays within the profit zone.

That’s the first decision.

Another question to ask would be how long do you plan on holding the trade if neither your profit target or stop loss have been hit? Can you incorporate a time exit into your trading strategy?

Another profit taking rule you might consider is – closing when the short options drop to $0.10.

Sometimes the opportunity cost of tying up your margin for the sake of squeezing the last few dollars out of the trade is not worth it.

Stop Loss

Having a stop loss is also important, perhaps more so than the profit target.

With calendar spreads, you can set a stop loss based on percentage of the capital at risk.

Some traders like to set a stop loss at 20% of capital at risk. Others might set it as 50%.

If your profit target is 50% and your stop loss is 50%, then any success rate greater than 50% will see you come out ahead.

Then it’s just a numbers game and making sure you have enough trades to make sure the statistics play out.

Whatever you decide, make sure it is written down and mapped out in your trading plan.

Adjustments

With double calendar spreads, I like to adjust before the stock reaches the breakeven price or slightly before.

Once the stock gets past the break even price, losses can start to run away from you if the stock keeps trending in that direction.

If the stock reaches the break even price and my stop loss has not been hit, I usually move the whole double calendar or just once side depending on the situation.

In other rare cases I might add a third calendar spread to widen out the profit zone, provided it’s within my plan to add more capital to the trade.

Short-Term vs Long-Term Double Calendars

By moving the bought options out further in time, traders can make their trade a long-term double calendar.

They can then potentially sell multiple months’ worth of calls and puts against the longer-term bought calls and puts.

Long-term trades have lower time decay because the bought options that are further out in time decay at a much slower rate than the shorter-term options.

Long-term trades have a higher vega exposure, but that doesn’t necessarily mean that they will be more profitable in the event of a rise in implied volatility because each month on the curve is impacted differently.

Generally speaking, a volatility spike will impact shorter-term options much more than longer-term options.

Double Calendar Spread Examples

Let’s see what happens in our Microsoft example if an investor adopts a profit target of 30% for these double calendars.

The double calendar with the $175/$200 strikes in our first example will result in a profit of $1102.50.

Its 30% profit target was reached four days later on June 12th.

The payoff diagram on June 12th shows that both the expiration curve and the T+0 line had risen due to a rise in implied volatility in both the short and the long options.

double calendar examples

At the same time, we see that the price of Microsoft remains centred in the double calendar.

This is the ideal scenario for the double calendar to profit.

The farther apart double calendar with the $160/$210 strikes has a net debit of $2195.

It reached its profit target in two days resulting in a profit of $755 at 34% of debit paid.

The narrower double calendar with the $180/$195 strike has a net debit of $4063.

It reached its profit target on June 15th resulting in a profit of $1300, or 32%.

Summary

Double calendar spreads are a nice addition to an option income trader’s arsenal because they are positive vega and can achieve big profits if the stock ends near either of the strikes.

This type of trade can also be used to hedge exposure on iron condors.

Given that the position contains options across multiple expiration dates, it’s important to have a solid grasp of implied volatility including how volatility changes impact options with different expiration periods.

The maximum loss is limited to the premium paid to enter the trade, but the maximum gain is unknown because of changes in implied volatility.

Double calendars can be traded using longer-term bought options which allows the trader to sell multiple months’ worth of calls and puts against the long options.

While double calendars are a positive vega strategy, traders still want the stock to stay within the specified range during the course of the trade.

Trade safe!

Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.

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11 Comments
  1. Harry says:

    Nice article. I trade calendars – both single and double cals – for a living.
    It’s possible to write a whole book on the subject.

  2. Dinesh says:

    Hi, nice article, but should have more adjustment ment plan when trade goes against you, Reqesting to cover the same

    1. Gavin says:

      Hi Dinesh, I wouldn’t worry too much about adjustments, keep in simple. Either your profit target gets hit, or your stop loss gets hit.

  3. rm rmm says:

    very good explanation .. thanks

    1. Gavin says:

      Thanks glad it helped you.

  4. Lokanath says:

    For weekly DCS, what is the percentage you can suggest? I am planning 2/1.5 risk/reward. I. e on capital employed.

    1. Gavin says:

      That ratio looks good.

  5. Robert says:

    What is the suggested number of days between the short and the long kegs
    I’ve seen 30 or 60 days?

    1. Gavin says:

      Yes, 30-60 days is pretty standard. You can also do 14 days which makes the trade a lot cheaper.

  6. Robert says:

    Gavin
    Thanks for your response. If I want to decide the number of days what would be the best for the overall success of the trade, not necessarily what will be the least expensive? Thanks

    1. Gavin says:

      I would suggest doing some backtesting with Option Net Explorer:

      https://optionstradingiq.com/optionnet-explorer-review/

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