Options Forum: Strangles, Spreads and Put Sales

It's a cold winter weekend, and hopefully you're hunkered down with some hot cocoa and some equally steamy options. Now's a good time to figure out how to play the Net stocks or work out a way to sell premium in these high-volatility times.

All that and more this week, but we've got some great guest columns in the works and reader questions piling up on the desk. Send any you have to the Options Forum, and let that cocoa cool off a little.

Strangling Reality

I've been investing in stocks for about a year. Recently, I've started looking at options as a way of increasing my returns. I have paid special attention to the Internet sector.

The only consensus about Internet stocks that I have found is that they move big. They never seem to stay in a narrow trading range. If that's the case, wouldn't buying puts and calls on the same stock be a good play? You can make money on the way up or down, as long as the stock moves considerably, right?

I tried this strategy with Yahoo! on a hypothetical portfolio, and the returns were phenomenal. On Dec. 2, I bought an equal amount of puts and calls at 185 and 210 for January. Now, a month later, this strategy has produced a 233% return, with the calls up 528% and the puts down 95%.

I like this strategy because it allows an investor to profit from the volatility of a sector that does not seem to obey any of the traditional rules of investing. It also eliminates the need to time a bull or bear run. It allows investors to join the party, but also to protect themselves once the bubble bursts.

-- Frank Pantazopoulos

Frank,

As someone new to options, you have made an astute observation about how to use volatility to your advantage. The position you describe is called a "strangle" (if you were buying the same strike price on each option, it would be a "straddle"), and it is commonly used by investors when they're playing a stock that can move drastically in either direction.

There's one problem involved in using options to play the Internet sector, however. Volatility is a key component in options pricing. The higher the volatility, the higher the option's premium. Internet stocks have absurdly high volatility levels, and their options are appropriately expensive.

Let's take a look at some February options on Amazon.com. According to McMillan Analysis, the implied volatility on Amazon options was 154% as of Jan. 8, 1999. That means the market is reflecting a belief that Amazon has the potential to move 154% in either direction.

Now, you can imagine what that does to options prices. In case your imagination is on other things -- such as a New York Jets-Minnesota Vikings Super Bowl shootout -- we'll give you a couple examples.

With Amazon trading at about 185, the February 170 puts cost 24 3/4 ($2,475), and the February 190 calls carry a 33 ($3,300) price tag. That means that Amazon has to move at least $58 (that's equal to the $5,775 for each pair of contracts you'll have to cough up) for you to break even. Remember, you're paying that much to buy the options, so the move has to not only take Amazon's stock price past the strike but move enough to make up for the premium you paid out.

Considering that Amazon.com has the potential to move $58 in a day -- sometimes it seems like the thing doubles hourly -- maybe you think that's a better bet than just buying the common and not being restricted by the expiration cycle.

Simply put, if you're going to start dabbling in options, make sure the premiums aren't too onerous. This kind of volatility won't last forever (will it?), and at some point those hefty premiums are going to result in a bloodbath for investors who have little regard for price.

Put Spread Scenario

If I sell a put at one strike and buy a put at a lower strike, what happens at expiration if the stock price has dropped below your long put?

For example, let's say I sell one Cisco January 105 put, so to hedge this position, I buy one January 100 put in order to limit risk to 5 points less the net premium. (Cisco was selling around 106 at the time.) I've taken in premium, so I regard this as a bullish position on Cisco.

At expiration, let's say Cisco closes at 95, and I have not closed either option position. (I lose 5 points less the premium received.)

Am I automatically assigned 100 shares of Cisco at 105, which I then have the right to sell at 100, incurring transaction costs on both sides? Or will my broker typically just work the profit/loss on my account? Please explain the mechanics at expiration.

-- Jim Lovett

Jim,

To answer your question, this is exactly where you will incur the $5 cost (maximum loss) of the spread you sold earlier.

You are assigned on the 105 puts and buy stock at $105 a share.

You exercise your 100 puts and sell the same number of shares at $100 a share. Now you have no stock position, but you lost $5 a share on the exercise and assignment.

Your $5-a-share loss in this transaction is offset by the credit you received when you originally put on the position (sold the put spread).

As you probably suspected, our friends in the brokerage business will charge a toll every step of the way. In fact, for them an exercise or assignment involves most of the same processes as buying or selling stock shares, so they will definitely charge two commissions, one on the assignment, one on the exercise. (If it's any consolation, even market-makers are charged for these things.)

I am told that the charge is the same as commission for buying and selling the equivalent shares of stock in the open market. Some firms discount commissions on exercises or assignments.

Put Selling 101

I sell puts, usually LEAPS. When a stock moves up so that the puts are significantly out of the money (40% to 50%) and there is plenty of time remaining, I buy the puts back and sell ones closer to the strike (15% to 20%) out of the money.

On occasion I sell significantly in-the-money puts (usually half the number of contracts) if the stock has pulled back but I believe the upside is still intact.

Do you have any comments or suggestions on this strategy?

-- Dave Ries

Dave,

When it comes to advice on a strategy, we like to bring in an expert to offer some in-the-trenches advice. For this one, we grabbed David Schultz, the president of Summit Capital Holdings and a frequent Options Forum oracle.

Schultz says selling puts is a good start, but you are leaving a lot of money on the table and taking some excess risk by using the LEAPS.

At Summit, Schultz says the he likes to sell puts two to three months out to capture the hyper time premium decay and give himself the option of rolling out to another month if the stock pulls back.

Schultz says he never sells in-the-money options because there is a high probability they will still be in the money when expiration comes around. Besides, if you are going to risk picking the direction of the stock, you might be better off buying calls. Buying calls means you have unlimited gain for absolute limited loss.

Schultz offers AOL as an example. "We bought January 90 calls at $9 and saw them go to $60-plus. If you had sold the January 90 puts for $9, you made $9, but so what? Maybe the holidays would have been a little warmer, but I had champagne and got a new fishing rod for a lot less risk," he says. All in all, when selling options, keep them within three months and out of the money, When you're buying options, go in the money and buy some time, more than three months, or LEAPS.

LEAPS vs. Bonds

I own the leaps on Hilton for 2001. I owned them before the spinoff.

I understand each LEAP now encompasses the Hilton and Park Place Entertainment stock on a one-for-one basis. I also owned the Hilton 2006 convertible bonds. As I understand it, these bonds are now only convertible into the Hilton common and not the Park Place common.

Why the difference between the bonds and the LEAPS?

-- Mat Horween

Mat,

Brad Zigler of the Pacific Exchange says you're right about the LEAPS: Each share of Hilton common was converted into the right to receive one share of Park Place common plus one share of new Hilton common. (FYI: The 2001 Hilton adjusted LEAPS began trading under the symbol ZHZ on Jan. 4, 1999.)

As for any potential adjustments to Hilton's convertible bonds, Zigler points us to the Hilton Joint Proxy Statement/Prospectus, dated Oct. 23, 1998, for an authoritative description of the transaction and all its terms and conditions. You should have received it well before the transaction's effective date.

There is no overarching rule that I know of. In fact, assuming the same underlying stock for both bonds and options, both should have the same deliverables. But each bond indenture is unique. Be sure to read the fine print in the deal's terms.