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Playing the AOL-Time Warner Options, Almost 30 Points Later

America Online's (AOL) deal with Time Warner (TWX) may be the marriage of the millennium, but so far it's lost people a lot of money.

Since Jan. 10, when the deal was announced, AOL's stock price has spiraled down from just above 80 to 52 at the close of trading Wednesday.

That's forced even Street pros like TSC's David Brail to scratch his head , a sign that retail investors should stay away.

Volatility Index
Today % Change
25.32 +0.88
Source: ILX
No? You're insistent? Fine. We'll show you a few ways to play a possible move in AOL with options.

AOL may rejigger the deal and pony up more money for Time Warner, given that it's stock price has spiraled lower, said Paul Foster with 1010wallstreet.com in Chicago.

No one has voiced it, but here's the reality: AOL may have to cough up some more dough in the next month or two if its stock doesn't revive (Time Warner shareholders get 1.5 AOL shares in the merger). That could hurt AOL's stock price even more in the short run, Foster opined, but remove some uncertainty. "Time Warner shareholders may stand up and say they want more cash, and there are always clauses in deals allowing each side to restructure," he added.

Options Buzz: Join the discussion on TSC Message Boards . Foster's fundamental belief is this: "The stock is ripe for dramatic upturn. AOL is down, people have been moaning about it, and it's expiration week. Everyone's on pins and needles." (He is long AOL stock, by the way.)

That assumes you buy into the cynical game that moves stocks: i.e., Wall Street analysts masquerading as independent voices on a stock, when in fact they are gunning for their firm to win investment banking business. Note that the major Wall Street brokerage houses cooing over the AOL-Time Warner combination early in the year -- remember the analysts who said AOL was a buy back in January? -- have been conspicuously silent.

Put/Call Ratio
Today (Noon) Previous Close
0.41 0.40
Source: ILX
Whew. OK, back to the option strategies. "The stock has based. And the Street hasn't yet come to the rescue. When will they?" Foster asked. "It's a matter of timing."

Morgan Stanley Dean Witter analyst Mary Meeker "did it for AOL when the stock was on its bumpkin last summer," Foster added. "She needs to step up to the plate here and say 'everything is fine.' Credit Suisse First Boston and the rest of them will follow and that's the way to look at it."

Under a scenario where the AOL-Time Warner deal watered down with more cash, "I would still get long the stock, and sell some AOL call options" because he fundamentally believes the stock price moves up. "Selling covered calls is a good idea, if you get in at a lower price to lock in gains. Buying AOL call options is expensive. Better to be long the stock, and short the premium."

Volatility is another key here in AOL options: it is the number traders plug in to an option price that is their estimate of how much the stock price will swing -- up or down -- annually. When volatility is low, options are cheap; when it is high, they are expensive.

Traders are plugging in a relatively low volatility of between 52 and 54 for AOL March 50 calls, for example. That's low compared to the triple-digit volatility of the past for this Internet juggernaut's options. "The pattern I've seen is that volatility will move higher in AOL," Foster said.

Ed Borgato, principal with Javelin Partners hedge fund, has another idea -- a straddle using AOL options. "The stock could be a straddle candidate, because it could move in one or the other direction dramatically from here."

Even if AOL drops, it appears to have a resistance level at 40, he points out. "I'm inclined not to try and figure this out -- I would rather wait and see," he says. (Borgato has no position.)

"But if you're insistent, 40 seems to be a good place to bet on support" and a good striking price for a straddle. A straddle, by the way, means buying an equal number of puts and calls with the same strike and expiration.

For the record, AOL March 60 calls are fetching 1 1/2 ($150) and the March 60 puts cost 9 ($900). Seems like a popular play already: those strikes represent the largest open interest, with roughly 37,000 and 32,000 contracts already "opened" in those option series.

"Warren Buffett said 'wait for a pitch you can hit,'" recalled another hedge fund manager in New York City. "You can just wait with AOL-Time Warner. You're not getting paid to swing."

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