Monday, March 2, 2009

An Options Play: Profit From High Near-Term Volatility, Buy Long Term Options

There is an interesting options play on some stocks and indices which takes advantage of high near term IV (implied volatility). We call this play the "Leaping Play".

What is IV:

"Volatility is an essential element in determining the pricing of options. It is a measure of the rate and magnitude of the change of prices of the underlying. If volatility is high, the premium on the option will be relatively high, and vice-versa." (Investopedia). Implied Volatility (IV) has a significant impact on an option’s price. An option’s price can go up or down due to changes in IV, even though there is no change in the stock price.


Consider XLF, currently trading at $7.60. You may buy long term XLF call options and repeatedly sell near term calls. For example:

-Buy Buy Jan 2010 Call 8 for $1.70
-Sell March Call 8 (quarterly) for $0.50.

If you repeat in April May and June, you will have the Jan 2010 options free or even at a profit.


Sounds simple. Let us examine the risks:

The risks are in both directions, first, that XLF keeps dropping, and second, that it rises quite significantly.

1. XLF drops signifcantly, let us say to $5. If XLF keeps dropping, you will pocket the premiums you sold as the near term options will expire worthtless. However, your long term options will also lose value. You can keep selling near term options in subsequent months, or you can also just move your positon to a lower strike and repeat. With say a $2 drop on XLF (to $5.60), the long term options will drop about $1. This is not ideal, but manageable.

2. XLF rises to $10. This is not so much a problem as both the long term option you bought will have also increase in price. Not as much, percentage-wise, as the near term option but about the same amount in $. If XLF were to increase dramatically, say to $20, both the near term and the long term option would rise to cover the intrinsic value of $20. The March calls would rise about $12, and the 2010 calls would rise about $11.50.

If XLF stays around the trading range of $7.60, you will earn those long term calls for free.


The same technique can be used with SPY. SPY is trading around $74.

- Buy Dec 2010 75 calls for $12.
- Sell March 75 calls for $2.90


The same technique can be applied to common stocks, which also suffer from the same IV phenomenon. The danger with the common stocks is that they can jump in price up or down, unlike indeces like XLF or SPY which cannot go bankrupt or will not double in a matter of days.

For these, the gains can be higher, but a little protection would be required, in the form of cheap puts.

For example, JPM trades at $22.80.

- Buy Jan 2010 22.50 calls for $6.90 or 25 calls for $5.75
- Sell March 24 calls for $1.60
- Buy March 17.50 puts for $0.55

Four or five more times doing this covers your purchase price of the 2010 calls.


Another example is WFC, which trades at $12.10.

- Buy Jan 2010 12.50 calls for $4.30
- Sell March 13 calls $1.70
- Buy March 7,50 puts for $0.50

Past Moves

The assumptions outlined above are based o what happened during recent moves.

XLF, moving from $7.30 to $8.50. The March 8 calls went up $0.48, and 2011 calls went up $0.70. This was actually profit for the long term calls.

You can view the actual prices in the chart below.

(please click to enlarge)

Similarly, SPY 85. SPY went from $85 to $80, and then to $75. The March calls dropped $4.10, while the long term calls dropped $6, but were still wroth $12 after the drop.

SPY 80: SPY went from $80 to $70. The March calls dropped $2.40, while the 2011 calls dropped $2.90 (and were still worth $13.80).

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