Doc Maher discusses Dollar Returns versus ROI.
You like the idea of selling covered calls (Play #6), but you would rather not tie up so much capital to own the stock. Is there an alternative? Some traders choose to substitute the underlying with a LEAP call. To read more about Calendar Spreads, please check out my previous blogs Calendar Spreads and Earnings, and Calendar Spreads and Volatility. Brian Overby has written a series on this topic as well; it begins here.
THE PLAY - Long Calendar Spread with Calls
This is Play #27 of The Options Playbook located in TradeKing's Education Center.
TRADE FORMATION
The initial post was a discussion of Pacman's Trade Notes on a Long Calendar Spread with Calls back on 5/21/08. Pacman's original trade:
On April 28 at 2:10, Community member Pacman entered the following:
Front-month Strike A Call: Sold to Open May Visa 80 Call (V EP) at $3.15
Back-month Strike A Call: Bought to Open September 80 Visa Call (V IP) at $7.75
Stock Entry: Visa near $76.92
Calendar entry: $4.60 debit
Maximum gain: Approximately $300 (Visa at $80 and no change in IV)
Maximum loss: Debit paid of $460
Break-even points at expiration: ~ $73.50 and $88.50 (estimated)
This trade will profit as long as Visa stays between the break-even points. The tricky part is that these points will change as Implied Volatility changes.
QUESTION - from Runningpair:
Doc - What do you think about a strategy of buying calendar spreads when IV is low? Buy the leap and sell the nearby. Perpetually roll near the money with the nearby until the leap expires. This is a strategy I use however when I started doing it the VIX was about 24. If you like the idea, what VIX quote would you use as attractive? Since the VIX was high when I started, it seems difficult to roll for attractive premiums.
ALL-STAR COMMENTARY
Runningpair,
I like the idea of buying calendar spreads when the IV is low because rising IV will help the calendar just like falling IV hurts it. However I tend to stay away from the LEAPs because they are more expensive. Whenever I consider it, the gain that comes from the LEAP's low time decay doesn't seem to justify the extra cost. If you look at it you will see that the LEAP strategy will have a larger potential dollar gain but a lower percentage gain. I know that many people like to use this strategy but personally I would rather use a long call cover that is closer in time and then if I want to keep playing this game I just move the covering call cover back further in time.
Here is a P&L for the LEAP case for Visa using June 2008 and Jan 2010 Calls:
Click here for a larger imgage of the LEAP Spread.
The max gain is $375 but the cost is $19.30 - $2.95 = $16.35 for a max return of 375/1635 = 23%
Here is a P&L using the September 2008 Calls to cover the June 2008 Calls for V:
Click here for larger image of the September Spread.
Here we have a max gain of only $289 but the cost is only $8.10 - $2.95 = $5.15 for a max gain of 289/515 = 56%. We also gave up some of the range, about $1 on the low side and $4 on the high side. So you have to make up your mind if the trade off is worth it.
Transaction costs are not that high that I am concerned about selling the cover option and buying another one a couple of months out. The ultimate extension of this chain of thought is to buy stock to cover; it never decays over time.
Also be careful and make sure that the price of the VIX options are reasonable, the VIX acts a little funny as you get near the extremes. Although it can keep going up there is a historical limit and the option prices may reflect that. I don't know if that is still the case as I haven't looked at it for a while.
"Income Trader"
For a list of previous All-Star Trades, please click here.
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Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
