How Soon After the IPO Can Options Be Traded?

What happens when options on volatile stocks start trading? And why can't you plug in your own implied volatility on a trade? We tackle these and other questions in this weekend's Options Forum.

Keep sending your options questions, with your full name, to [e-mail].

Options Trading on New Issues

Shares of Tibco Software (TIBX Quote) started trading July 14. Options on Tibco started trading July 28.

This is the first option trading that started within two weeks of an initial public offering that I have noticed. What are the conditions market makers typically look for to start option trading on a particular equity? Is there more to be read into such a quick start of option trading on this recent IPO of Tibco?

-- Subodh Nijsure

Subodh,

On this question, we consulted Michael Bickford with the American Stock Exchange's derivative marketing and research division (also a Red Sox fan and therefore a hardy soul). He immediately pointed out that Tibco is a "spinoff from Reuters (RTRSY Quote), and there are different rules for trading for options of spinoffs than for straight IPOs."

The Securities and Exchange Commission lets the option exchanges look back at the trading volume of the parent company and use that for historical comparison; that's why spinoffs are allowed to have options faster than regular IPOs, says Bickford.

For a straight IPO, "it depends on how quickly the company meets trading volume and other criteria." As for market makers, "they don't decide when options start trading. Each exchange has a process to decide the stock selection. We here at the Amex have a committee of floor members and trading desks; we go through the universe of eligible companies [there are lots of them] and decide whether we should trade them. Though there are plenty of choices, lots of stocks don't trade actively, so it's difficult to make a deep, active options market for them."

Thanks, Mike. Here's hoping Boston gets the wild-card spot.

Trading Volatile Options

Would you please explain what happens when options are first listed on a rather volatile stock? Take Healtheon (HLTH Quote), for example. The Amex started listing options with strikes at 25, 30 and 35. So much is going on with that stock. The lockouts are ending, millions of new shares can be traded, etc.

-- Frank Barish

Frank,

It's a guessing game, even for the pros. But wide spreads on prices are often the most obvious characteristic of an option on volatile stocks.

We rang up Brent Houston, vice president of capital markets at his new job developing options trading for Datek Online in Edison, N.J. His answer:

It goes back to implied volatility. Frank, you take historical volatility on the underlying stock (the amount the stock has moved up or down on an annualized percent basis), then apply that to classic options pricing models to determine your theoretical price. The two best-known models are Black-Scholes and Ross-Cox.

From his days trading on the Pacific Exchange, Houston recalls friends on the trading floor "who've traded Yahoo! (YHOO Quote) and Amazon.com (AMZN Quote) who make the spread 2 points wide, even when it's an $8 option, partly because the stock would move so fast, they didn't have time to buy the stock and hedge the options they just traded. If you look at almost all the Internet stocks, for example, that would happen."

Over time, ideally, the stock starts to settle down, and traders ratchet down the volatility percentage they plug into an options price. "As the stock starts trading more normally and with liquidity, then the spreads should narrow for the option prices," he adds.

Advice? "I wouldn't enter a market order" for a new, volatile option. "Pick a price you feel comfortable with and don't keep chasing it. The option might come back down to the price you were looking for."

Plug In Your Own Implied Volatility

I have been unable to find online brokers that will allow me to enter an order of the following type: buy 150 IBM (IBM Quote) calls at 35% implied volatility.

Now I know that everybody's option model is slightly different, so that my 35% implied volatility might be 36% implied volatility (different interest-rate assumptions, volatility skews, etc.). But surely I should have the ability to say, "Buy the 150 IBM call at X% of the underlying share price."

And as long as I'm looking for a service I'll never find, are there any online brokers that will accept spread orders (i.e., I bid $7 for the $150-to-$170 call spread), and not force me to put in two orders, (buy 150 call, sell 170 call), leaving it possible for me to be executed on one leg but not the other?

-- Tony Corso

Tony,

Short answer to Question No. 1: "It can't be done -- at least not right now," says Datek's Houston.

But obviously, Tony, you're sophisticated enough of a trader to know that if you're concerned with volatility you'll pick your price point, he adds. "You can use the Ross-Cox model and the Black-Scholes model. They each calculate it differently. From a broker-dealer perspective, we're only concerned with the actual price of that option," he says. "Implied volatility doesn't exist unless the option is being hedged with stock. So if you're just buying an option, all you're doing is speculating on pure direction. What creates implied volatility is when you hedge the option with underlying stock; that's what market makers do."

So unless you're doing something more complicated than just a straight option, you don't really need to be concerned with volatility, Brent adds.

He lays out the reasons why: "If the market maker is selling and the customer is buying that IBM call, for instance, the market maker sells the call and hedges it with stock. The customer buys the call and expects the stock to go up. The customer makes money on the option, and the market maker earns money on the long stock position."

Let's say the customer closes that position with that same market maker and sells the option with a minute left to expiration. "There's no implied volatility left in the price. All it is is intrinsic value," Houston points out. "All of a sudden, the market maker is buying the option back at zero volatility. The customer made money on the price of the option change; the market maker made money on the volatility decreasing," so he or she can buy it back from the customer at a lower price than what it was sold for.

If you are concerned with volatility, it should be because you're executing a trading strategy such as a buy-write (that's where a customer buys a call and sells the stock). "Put in a buy-write order; buy 10 calls, say, and sell stock against it at a specific price. Tony, you can determine that price by using the Chicago Board Options Exchange's Options Toolbox software, plugging in the volatility and arriving at the theoretical value at the specific stock price."

As for Question No. 2, Houston recommends visiting Preferred Capital's Web site and downloading the software for spread trades. (As always, TheStreet.com does not endorse, smile or frown upon any software or Web sites. And, as usual, with options, caveat emptor).