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Wednesday, January 18, 2012

How to adjust a Double Calendar Spread

This is something I was looking for on Google and was not that easy to find. So, I'll give it a shot myself with the little I know. If you landed on this page via a Search engine then you probably know what a Double Calendar is. If you don't, then read this.

What often happens with this kind of positions is that the market never stays in the same place and may threaten to reach one of your breakeven points. Let's analyze for example a hypothetical position on XYZ.

XYZ is trading around $100 on December 23. Just 28 days before January expiration. Selling January options (expecting them to lose value) while at the same time buying February options for protection would result in a Calendar position where the trader benefits due to the fact that the time decay on the options being shorted is greater than the time decay on the February options bought for protection. Ideally the options being shorted are also overpriced, and the implied volatility can give a clue on that.

Let's assume we enter the following Double Calendar position:

SELL 1 January 90 PUT @1.00
BUY  1 February 90 PUT @2.00
SELL 1 January 110 CALL @1.00
BUY  1 February 110 CALL @2.00

Net Debit 2.00 ($200 maximum loss)
The trade is profitable if by expiration the XYZ instrument is between 78 and 122.

Eight days later XYZ is trading at $120, very close to the $122 upper breakeven point, and therefore threatening the position. Instead of 28 days to expiration, we are now 20 days away. At this point you might exit the trade or adjust it if you think the market has gone up too much too fast and it's due for a reversal sooner than late.

What you do is you enter another Double Calendar on top of the existing one but using higher strike prices! So, if the initial position was open using 90 and 110 as the strikes of choice, you can enter another one using the 110, 130 strike prices like so:
And the combination of both Double Calendars results in a profit picture approximately similar to the following:
The result is a profit picture with a wider profit range. You have given yourself some more padding in the upper side while now the position needs less time to get to expiration, resulting in a profitable one. Essentially you have increased your odds of winning the position.

Now, this doesn't mean this is the perfect trading strategy or anything like that, in fact there are a few disadvantages to adjusting a position:
  1. The risk/reward balance is affected. If the initial picture showed a $200 risk vs a $300 maximum reward, the adjusted position will probably show a $400 or higher risk for a $300 maximum reward or perhaps a bit more that initial but not much more. So, now you are risking more to proportionately make less.
  2. Your loss in commissions is now twice as much. You have two Double Calendar spreads, that is 8 different options being played (4 calls at different strike prices and 4 puts at different strike prices).
You obviously need an options friendly broker for this type of positions and a decent commissions schema otherwise you're eaten alive by your broker.

Of course XYZ could keep moving up after this and threaten the new upper breakeven point, although chances are, if the market was overbought and expiration being closer you ended up with a profit. But, if XYZ is like a rocket going to the moon, 2 points up every day, then you might want to close the whole trade, or close the initial Double Calendar and only leave the second one. That would automatically lock a loss on the first Double Calendar, but the second one would change the profit picture reflecting now an even higher upper breakeven point. Hopefully the profit in this second Double Calendar offsets the locked loss on the first one closed earlier.

On a final note, I arbitrarily chose the 110 - 130 strikes for the second Double Calendar, and the 110 happened to be the same strike used for the calls of the first Double Calendar. That doesn't need to be the case in reality. You could have adjusted using the 105 - 125 for example or something else. Also, when you enter the second Double Calendar, you don't need to enter the same number of contracts used in the first position. There is no rule saying that. So, you can play around with the numbers of contracts to play on the second Double Calendar and see how the profit curve will end up. Usually a better profit curve will result from using more contracts than in the first Double Calendar. Just play around with the profit curve adjusting strike prices and number of contracts for the second position and once you feel comfortable with the profit picture obtained then "Send Order"!

Related Articles:
Adjusting an Iron Condor
Different ways to adjust an Iron Condor

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  1. I do a lot of these and you are almost right :-). The one thing you have forgotten is that both straddles can end up losing their max, making it very difficult to adjust no matter what you do! This happens if you put on the second double calendar and then the stock moves outside of the lower or higher levels created by the new wider sraddle. I have had this happen and you can lose a good amount of money. These trades can also make a lot of money when you get lucky with volatility increasing and the underlying still being close to the original day of the trade. These two things can happen near earnings.

  2. Thanks for your comment! Yes, definitely volatility is one of the main aspects to consider here with calendars. Which I didn't talk about in this articles.