Verticals and calendars are option trading’s foundational spread strategies. But what about other option strategies, like condors, diagonals, and unbalanced butterflies? It could take years of articles to cover them all, right? Maybe not. Just about all of the more complex strategies are built by combining verticals and calendars. So understanding them is more than academic.
It’s Complicated, But Not That Complicated
When I started trading bond-futures options, I would accumulate long-and-short calls and puts at different strikes and expirations. This was before trading software. So to fix my position risk, I had to figure it out by hand, and found spreads from inside my whole position with relatively low delta—spreads like butterflies and verticals that probably wouldn’t change much in value even if bond futures moved up or down a point or more. The goal was to isolate the individual calls and puts, long or short, that didn’t fit into a defined-risk spread. Those leftover options represented my risk and I knew which positions I would need to close or otherwise deal with if bonds moved against them. And making, say, two decisions at 7:30 in the morning was easier than making fifty.
That was then. Now, I don’t have many overlapping positions. But I still use these techniques to understand complex spreads and better identify risky position components, or those parts sensitive to changes in stock price, time, or volatility. The goal here is to show you how to think about complex positions as a sum of their simpler parts.
Warning: Math ahead. Grab a coffee and a whoopie pie before proceeding.
First, recall what the risk profile of both a long and short vertical spread looks like. Note that in both cases, the spreads are designed to profit from the stock trending in at least one direction. In the case of the short vertical, the stock can stay the same, or even move against you a little bit.
Now let’s start by combining long and short verticals. All butterflies, condors, and other “wing spreads” are composed of combinations of long-and-short call, and/or put, verticals. Sum up the total of a single expiration’s long-and-short calls, as well as the long-and-short puts. If the sum is zero, chances are you can use verticals to evaluate a position.
Assume XYZ stock is trading at $50. Let’s revisit the basic long and short vertical spread.*
The Long Vertical. Think about the long 48/49 call vertical trading at .70 debit. This is a bullish position that makes money if XYZ is above its break-even point at $48.70 at expiration. It loses money if it’s below $48.70. The max profit is $30 if XYZ is above $49 at expiration, and the max loss is $70 if XYZ is below $48. That means XYZ can drop $1.00 from $50 to $49, and this bullish position can still make its max profit.
The Short Vertical. Now think about a short 52/53 call vertical trading at .20 credit. This is a bearish position that makes money if XYZ is below its break-even point at $52.20 at expiration. It loses money if it’s above $52.20. The max profit is $20, if XYZ is below $52 at expiration, and the max loss is $80 if XYZ is above $53. XYZ can rally $2.00 from $50 to $52 and this bearish position can still make its max profit.
If we combine the long 48/49 call vertical as well as the short 52/53 call vertical above, we should have a position that shares characteristics of the two—the 48/49/52/53 long-call condor (Figure 1, below). This condor has a debit of .50, which is the net debit of the long 48/49 call vertical, and the short 52/53 call vertical (.70 - .20).
How the strategy plays out at expiration depends on where the stock price ends up. If at expiration XYZ is:
1. BELOW $48—The long 48/49 call vertical loses $70, but the short 52/53 makes $20. The net is a $50 loss, which is the max loss of the long-call condor.
2. ABOVE $53—The long 48/49 call vertical makes $30. But the short 52/53 call vertical loses $80. Again, the net is a $50 loss, the max loss of the long-call condor.
How the long-call condor makes and loses money is nothing but a combination of its two verticals, one long, one short. Why is this important?
If we understand the long-and-short call verticals that make up the condor, we can see that the 48/49/52/53 condor has a somewhat bullish bias. While the long 48/49 call vertical can still make money if XYZ drops $1, the short 52/53 call vertical can still make money, if XYZ rallies $2. That extra “room” on the upside gives this condor a slightly bullish bias.
Compare that to a long 46/47 call vertical, and a short 51/52 call vertical. That’s a long-call condor, too—the 46/47/51/52. But XYZ can only rally $1 to $51 before the short 51/52 call vertical starts to lose money. But, it can drop $3 to $47 before the long 46/47 call vertical starts to lose money. That condor has a bearish bias, even though it contains two call verticals, each with different directional biases. The condor verticals you choose determine position risk, and how far the stock can move in any direction before the condor starts to lose money.
Still with me? Now let’s look at how verticals and calendars together can make up an inter-expiration strategy. First, recall how the risk profile of a calendar looks like in Figure 4, and note that the spread is designed to profit when the stock trades in a range, rather than trending. The diagonal changes the shape of the calendar to take advantage of both time and trend.
When you combine a short-vertical spread with a long- calendar spread, you get a position that shares characteristics of the two—the diagonal. (Figure 2, below)
Start with a short Sep 47/48 put vertical for a .35 credit in a $50 stock. That’s long the 47 put and short the 48 put for a net .35 credit, with a max loss of $65 if the stock is below $47, and a max profit of $35 if the stock is above $48, with a breakeven point at $47.65.
Now, add a long Sep/Oct 47 put calendar for a .20 debit, which is short the Sep 47 put and long the Oct 47 put. That calendar has a max loss of $20 if the stock is higher or lower than $47, and an undefined profit if the stock is right at $47. When you combine the short vertical and the calendar, the long 47 put from the short vertical is offset by the short 47 put from the long calendar. The resulting position is the short Sep 48 put and long the Oct 47 put, which is known as a “diagonal,” for a .15 credit. Like a calendar spread, the greatest profit occurs at the short strike. Yet there is a slight bullish bias as a result of the short-put vertical.
So the diagonal is made up of one position that loses money if the stock goes to $47 (the short vertical), and one that makes money if the stock goes to $47 (the long calendar). But they’re not equal. The short 47/48 put vertical has more delta than the calendar spread, particularly as expiration approaches. If I have a diagonal on that’s losing money, it’s the short 47/48 put vertical component I look at first. What’s the vertical trading for now? How much additional risk do I face? If I continue to hold it, would the long calendar spread generate profits—or additional losses—if the stock stays at its current price? No right answer but lots of choices. Knowing that the diagonal is composed of a short vertical and a long calendar can make your choices clearer.
Doing this “untangling” of complex positions into verticals and calendars can help you see if adding new positions reduces or increases risk. Does a long vertical close out a short vertical embedded in an unbalanced butterfly? Or does it increase a condor’s directional exposure? Ultimately, you can extend this analysis to your whole portfolio. If you isolate where risk is concentrated by evaluating the risk of simpler components across various underlyings, you can make more efficient decisions about how to reduce risk.