Now, let's examine the risk profile for an example double calendar trade.
To do this, I'm going to once again use the Analyze tab on paperMoney®.
We'll begin by setting up our double calendar trade here, in the Add Simulated Trades subtab.
I'm going to follow the rules in the sample investing plan.
For this example, I'll use a widely traded stock.
I'll begin with the short options.
Because I want to balance time decay and premium, I'm looking for weekly options that are
between seven and 10 days from expiration.
It looks like these options that expire on February 9 of 2018 have 9 days until expiration,
so I'll use them.
Next, I need to select the strike prices.
I'd like to sell calls and puts with a lower likelihood of assignment, so I'll choose
the strike where delta's closest to .30.
On the calls side, it'd be the 175 option, with a delta of .27.
To add it to this simulated trade, I'll click the bid price.
Now I'll do the same with the put.
I'll use this put, which has a delta of -.26.
Before I click the bid price, I'll hold down the control key to combine the options
into a single trade.
Next, we'll need to buy the long options.
Because I want to create positive vega and allow for potentially rolling the short options,
I'll look for contracts 30 to 50 days from expiration.
This is about two to three weeks later than the short options.
The 2 MAR 18 options appear to be in that time frame.
Calendar spreads use the same strike prices in the short and the long options.
So, the long call will use the same strike price as the short call.
The long put will use the same strike as the short put.
First, I'll select the 175 call.
Because we're buying this option, I'll once again hold down the Control key, then
click the ask price.
I'll add the 160 put the same way.
Now, that we've added all four strikes, I'll adjust the quantity down so we can
analyze a single spread.
Okay, it's time to analyze our double calendar.
So let's click the Risk Profile subtab and take a look at what we've built.
Here's our risk profile.
It sort of looks like a circus tent.
The green line is the risk profile at expiration and the purple line is the current risk profile.
With that said, keep in mind, this example doesn't account for commissions and fees.
However, for your own analysis, it's a good idea to factor these in.
You can do so by changing the Commission settings at the top of the risk profile from EXCLUDE
to INCLUDE.
So let's look at some of this trade's significant price points.
There are two max profit points.
One is achieved if the underlying closes around 160, with a max of $3,000.
The other occurs if the underlying expires around 175, with a max of $3,500.
Also, there are two break-even points at around $153.50 or so and $183.70.
Let's take a moment to focus on the purple line—the trade's current value.
As I click off a few days, you'll see this line rise.
This illustrates how the trade generally becomes more profitable over time due to positive
time decay.
However, perhaps the most interesting impact on double calendars comes from changes in
implied volatility.
Let me show you what I mean.
First, above our simulated trades, click the gear over on the right to display a few additional
controls.
Now, I'm going to increase the implied volatility for this spread by 5%.
Watch what happens to the risk profile.
Did you see that?
Both the green and the purple lines moved higher.
Therefore, this trade has the potential for infinite max gain as long as implied volatility
keeps rising.
This is theoretical of course--implied volatility most certainly cannot rise indefinitely.
What this does show us is that rising implied volatility can lead to larger returns.
The opposite is also true.
Falling implied volatility results in losses.
Let's see what happens if implied volatility fell 5% instead.
Now the entire trade shrinks.
If implied volatility continues to fall, the entire risk profile can end up below break
even.
By looking at the risk profile, you can get a sense of how the trade works.
From a price perspective, the trade is neutral.
It gets most of its profits from time decay and rising implied volatility.
However, if implied volatility decreases, the trade will suffer.
If you want a challenge, I recommend trying this out a few of your own paper trades.
It's an effective way to really understand what needs to happen in order for this strategy
to be profitable.