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On February 2, 2009, we began a new Real-World Trading series that compares a Buy-Write strategy with a Calendar Spread. Both strategies take advantage of high IV on a security's options. In our scenario, we chose to use the Financial Select Sector SPDR (XLF) because of the high IV found on this SPDR. Before we look at the two mock trades, let's do some review on these particular strategies.

Implied volatility is a very important part of an option's price. When IV is high compared with past values, we considered an option expensive. When something is expensive, we normally like to be sellers. When IV is low, the option is considered cheap, which is a time to normally buy options. The buy/write and calendar spread are similar, but have some key differences.

The buy/write is the combination of long stock and short a front month call. A stock's value doesn't change because of volatility, but an option does. Therefore, with this strategy, we are buying stock that we feel will move slightly higher over time and selling a call at or out of the money to bring in premiums. The disadvantage of this strategy is the cost to enter because we have to buy the underlying security. The advantage is that we are taking away the risk associated with buying an option that has high IV.

A calendar spread is the buying of a longer term option and the selling of a short term option using the same strike price. The idea is that we can benefit from a mild gain in the stock, but benefit from time decay of the short option. Time decay is much higher in the last month of an option's life. Here is an example of how time decay impacts an option.

XYZ @ 45
50 call strike with IV @ 100
120-days - 8.44
90-days - 7.06
60-days - 5.41
30-days - 3.28
15-days - 1.84
10-days - 1.25
5-days - 0.56

We see that a four-month option loses just 1.38 in 30-days given the parameters set above. However, in just the two weeks, the option loses 1.44 in value from 30-days to 15-days left. The percentage loss is much greater as well and this is why we want to use front month options when selling calls. We can see this phenomenon by looking at the two mock trades we entered last week.

Some might wonder why we would use the XLF instead of an individual financial stock. The main reason is that we are taking out the risk of the underlying falling to zero and it takes away some of the volatility. Even so, XLF options are still showing very high IV. Below is the data for the buy-write mock trade.

Jan. 30
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

Feb. 6
Long 500 XLF shares @ $9.79
Short 5 XLF Feb. 10 Calls @ 0.67 (IV=100.5)
Cost to buy shares = $2,310 (use of margin at 50%)
Credit from selling calls = $280
Max Reward = $660
Current Profit = $220 or 9.52%
Max Risk = $4,340
Breakeven = $8.68

Figure 1: XLF Buy-Write Risk Graph

Now compare this data with the information for the calendar spread below:

Jan. 30
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
Downside Breakeven = $8.31
Upside Breakeven = $12.68

Feb. 6
Long 5 Jun09 10 Calls @ 1.70 (IV=78.7)
Short 5 Feb09 10 Calls @ 0.67 (IV=100.5)
Total Debit = $440.00
Max Profit - $424.00
Current Profit = $75.00 or 17.0%
Downside Breakeven = $8.30
Upside Breakeven = $12.69

Figure 2: Calendar Spread Risk Graph

We can't say that the buy-write is better at the moment because it has a higher current profit. This is because this profit has been achieved using a larger amount of capital. In fact, when we look at the return on investment, the buy-write has a 9.52 percent return, but the calendar spread has returned 17 percent.

The calendar spread has seen the long call improve by 26-cents, but with the short call adding 10-cents. This provides a 16-cent profit with XLF shares closing Friday's session at $9.79. With just two weeks left, if XLF shares remain below $10, the short option will lose its value much quicker than the long call. The same can be said for the buy-write with the short call losing value quickly. One other advantage to owning the buy-write is that XLF shares do not expire. Thus, if you like the security long term, you can hold it for as long as you wish. Of course, the calendar spread long call expires in June, though we could use the long call to purchase XLF shares at $10 if we wanted to.

I would love to hear from you on my forum so that we can discuss any questions you have. It also is nice to hear your opinions on adjustments and changes you would make to the various trades we discuss.

To read previous installments of Real-World Trading, please click here.

Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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