Straddling Your Way Through Options Trades

Seems you can't talk to anyone in the options market lately without hearing how cheap options have become compared with earlier in the year.

If something's cheap -- like the $7.99 motorized callus remover in Dr. Leonard's catalog -- obviously there's little desire to buy it, right? Well, when considering options plays, that may not necessarily be the case. Unlike the amazing callus remover, when options are cheap they probably won't stay that way. That could mean profits for you.

When prices for options are low, as they are generally right now, they provide the opportunity to implement a strategy that doesn't require a bet on the direction of the underlying security's movement. It's called a straddle . While straddling can imply indecision, buying an options straddle shows quite a strong conviction that a stock will move big; it's just that the buyer hasn't quite decided in which direction that move will be.

A straddle is built when you purchase an at-the-money call and an at-the-money put , meaning the strike prices and expiration month of those options are identical. An at-the-money option has a strike price as close as possible to the current share price.

Options prices have moved lower because the market has rallied. And some market analysts are expecting prices to move even lower, in part because earnings season is largely out of the way. Uncertainty around earnings helps inflate the price of options. Now that the unknown of this past quarter's earnings season is through, some market participants don't see many big catalysts for notable market moves.

When you buy a straddle, you profit if the move in the underlying security, either up or down, is greater than the amount of money you shelled out to purchase the options. The most you can lose in a long straddle (buying the straddle is known as being "long" the straddle) is the amount paid to buy the options contracts.

Here's an example of how an investor could establish a straddle on Intel (INTC).

On Thursday afternoon, Intel's stock was up 75 cents to $37.75. So you'd want to buy July 37 1/2 options. The calls cost 5 5/8 ($562.50), while the puts were at 4 7/8 ($487.50). The premium paid to buy the straddle is 10 1/2 ($1,050).

For the straddle buy to break even, Intel has to trade either up to $48 or down to $27. That's to break even, not including commissions for doing the trade, and those vary. Intel in the past six months has traded as high as $75.81 and as low as $29.81.

One option is likely to expire worthless, but the appreciation of the other option will make up for that loss. If there is a significant move in one direction, one option will expire worthless and the other will likely appreciate quickly. (You can even sell the option contract that is a loser using the scant premium you'll get back as a consolation for the lost leg of the straddle. In addition, if the stock really moves, you can just blow out of the position on the winning side to take profits in full, or a little bit at a time.)

Options guru Larry McMillan of McMillan Analysis, in a chapter he wrote for New Thinking in Technical Analysis, outlines several criteria for initiating a straddle buy.

He says four criteria should be satisfied before buying a straddle: Implied volatility must be very low; a probability calculator should be used to show that the stock has an 80% chance of reaching the straddle's break-even point (there are software programs that can do the probability calculation for you); analysis of past movements in the underlying security needs to display that it has moved the required size in the required amount of time; and there is no fundamental reason why volatility is low.

Also, when figuring out a break-even point for buying a straddle, don't forget to factor commissions into the equation. At Mr. Stock, an online brokerage, it costs $31 for a customer to execute a one-contract straddle. That breaks down to $14 per leg for the position, plus $1.50 per contract.

Buying a straddle is also a form of what is known as "trading volatility" because investors aren't making a directional bet on a stock, but hoping to profit merely from a dramatic movement.

McMillan suggested a volatility buying strategy should be used in options with at least three months but, ideally, five or six months until expiration. Options that far away from expiring aren't heavily affected by time decay -- another important element in an option's price.

Of course, traders will have to look at the implied volatility on individual stocks and think of a time horizon on those options they're considering buying. The longer dated the option, the more you'll pay for it. It can work because time value decreases as the option gets closer to expiration, but for most individual investors, paying for a bigger time cushion for your strategy to work is worth the extra cash.

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