The stock market has been a rough place to be during the past year, with the standard buy-and-hold strategy taking a hit. Many investors are now seeing advantages to shorter-term trades that have specific risk and reward parameters. Options were developed to hedge risk, but, as with any tool, they can be used in an inappropriate way. In this Real-World Trading column, I hope to help option traders understand the various strategies available to them and how and when these strategies can help them profit from month to month.

One of the biggest advantages of using options is the diversity they offer. Stocks profit when the market moves higher, but this is often the limit of their profitability. Yes, dividends can be used as an income strategy, but if the underlying falls sharply, like the recent decline in financials, then the dividend can't offset losses and the dividend can always be taken away. Traders can sell stocks short, but this is often difficult to do and can be extremely risky. However, by using options, we can set up strategies that profit in any type of market environment and that offer limited risk.

One strategy that we at Optionetics often discourage is the buy-write, but I want to show why, in the current market environment, this could be a nice profit maker. A buy-write strategy is also called a covered call. This strategy includes the buying of a security and then the selling of calls against the stock. By selling calls against the stock, an income can be brought in each month. However, the risk is that the underlying security could fall sharply and this could leave the trader with large losses, despite the income made from selling calls.

One alternative to using a buy-write is to enter a calendar spread. This strategy is very similar to a buy-write, but we are buying a longer-term call option instead of the actual security. Buying a call on a security costs much less than buying the security outright. The max loss of buying a $5 call is much less than watching a $40 stock drop to single digits and this is something we have seen many stocks do this past year. However, because many securities have fallen so far, we can enter buy-writes that have much lower risk, but provide nice profits from month to month.

Implied volatility is a key component of the price of an option, so when IV is high, we would like to sell options; when it is low, it is the time to buy options. History shows that option IV tends to be mean reverting, which means that IV will stretch from low to high levels, but tends to snap back to an average level. When we sell a call that is showing high IV, we are receiving more premiums for the sale. Here is a very simple example:

XYZ stock @ $20
ATM call option price with 30-days until expiration
20% IV Price = $0.47
40% IV Price = $0.92
80% IV Price = $1.83

This shows just how much the premiums we receive can change depending on the IV of the security''s options. In the current state of the market, IV is very high on many sectors, most notably the financial sector. If we were to enter a calendar spread, we would benefit from the high IV on the sold calls, but this would be offset by the high IV on the purchased longer-term calls. Therefore, with financials falling so far this past year, we are going enter a mock buy-write using the Financial Select Sector SPDR (XLF). This SPDR includes companies from across the financial sector, including banks, insurance and diversified financials. On Friday, Jan. 30, the SDPR closed at $9.24, although XLF shares have traded in a 52-week range from $8.07 to $29.93.

We will use in our mock trade the purchase of XLF shares and the simultaneous selling of front-month calls. Here is the data for the trade:

Buy 500 XLF shares @ $9.24
Sell 5 XLF 10 Feb. Calls @ $0.56 (IV=97.5)
Cost to buy shares = $2,310 (use of margin at 50%)
Credit from selling calls = $280
Max Reward = $660 or 28.6%
Max Risk = $4,340

At first glance, this data might seem to have too much risk and this is something that has to be discussed. The fact is that XLF shares have fallen sharply and the volatility in the financial sector has put IV on XLF options at very high levels. By buying the actual XLF security, we eliminate IV risk that would be associated with buying calls instead of the security. We can't use margin when buying longer term calls, but we can when buying XLF outright. This is why the cost to buy the shares is $2,310 instead of $4,620. The risk of XLF going to zero is virtually eliminated because it is diversified across dozens of stocks. Here is the risk graph for this particular trade:

Figure 1: XLF Buy-Write Risk Graph

We still have the option of using a calendar spread instead of the buy-write, so I would like to also track this strategy simultaneously. Looking at a calendar spread, we do have rather nice set up with this strategy as well.

Here is the data for using a calendar spread:

Buy 5 Jun09 10 Calls @ 1.44 (IV=78.4)
Sell 5 Feb09 10 Calls @ 0.56 (IV=97.5)
Total Debit = $440
Max Profit = $423

Figure 2: Calendar Spread Risk Graph

Obviously, this trade has much less risk overall, but if IV were to drop sharply on the June options, the value of our long position would drop. Of course, both trades allow us to continue selling options month to month if XLF shares remain in their current range.

From week to week, we will update discuss these two mock trades and dive into further details about both a calendar spread and buy-write strategy. Please feel free to ask any questions or make comments on my forum. We all learn from each other and by having open discussions, we can develop even better trades.

Jody Osborne
Senior Writer & Options Strategist

Optionetics.com ~ Your Options Education Site
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