Option direction neutral strategy – Straddle Swap
A Long Diagonal Straddle Calendar Spread, also called Straddle Swap, is a market-neutral option strategy implemented when investors expect low volatility on the underlying price in the near expiry Straddle. Indeed, a Straddle Calendar Spread is built through the sale of a near expiry Straddle and the buy of a far expiry Straddle.
The investor will benefit from the rapid time decay of the straddle sold and will seek a volatility upswing on the straddle bought.
As this strategy is a time value trade with different maturities, the payoffs cannot be plotted properly. Payoffs of both straddles are illustrated below:
The potential proﬁt in this trade arises as a result of the differing rates of time decay between the two straddles, which means that the theta is the most important parameter to monitor in this strategy.
The maximum proﬁt of this strategy will be reached if the sold straddle expires worthless, and after this expiry, increased volatility drives the purchased ITM straddle. Alternatively, the straddle bought can be sold for its time value before its maturity.
On the contrary, maximum loss will occur if the sold call is exercised and the market subsequently moves unfavourably or do not move at all, driving the purchased straddle OTM such that it expires worthless or can be sold for its time value only (if the investor decides to sell it before its maturity).
A Straddle Swap is Theta positive as the straddle sold is a near expiry, meaning it will get bigger as the maturity comes closer. The theta of the straddle bought is negative but far less important as maturity is longer. The global vega is positive as the investor bought the long-term straddle with a huge vega and the sell the short term one with a small negative vega. The position is delta neutral as it involves two ATM straddles. Finally, depending on the implied volatility and underlying moves, delta and vega can be impacted and become negative or positive.