Don't get caught in a naked strangle. No, this isn't the closing line from last night's broadcast of

Homicide

. Just a few words of advice from your humble Options Forum.

This week's forum tackles strategies known as strangles and straddles, including whether your broker will do it for you, and also whether, as a retail investor, the cost is worth your while.

If you have interests outside of the glamorous world of straddles, keep sending your questions to

OptionsForum@TheStreet.com and be sure to include your full name.

Strangling Brokers

I tried to put on a strangle trade yesterday, only to find that my brokerage account is not approved for naked sales and won't be for at least a couple of months. (They need to see more experience with the product.) Specifically, I was trying to sell a call and a put, both out of the money, on the Treasury yield. For a number of reasons, I believe the yield on the long bond will be rangebound for a couple months, and was looking to take in the premium on out-of-the-money calls and puts. However, this trade was denied. The broker won't allow me to make uncovered sales at the moment. The person I dealt with at the brokerage said something about being able to put on a strangle with a long call and long put position. However, I believe this is exactly the opposite of what I wanted to do, because that would be betting on an outsized move in either direction, whereas I think the movement will be neutral. Is there anyway I can profit from a neutral market without making a naked sale? -- Duane Schellenberg

Duane,

Brent Houston, managing director with

Mr. Stock

in San Francisco, took the time to sort out the two different kinds of strangles. By the way, a strangle is a combination involving a put and call at different strike prices but with the same expiration date.

Investors can be either long or short a strangle, Houston says. That means you, as the investor, either own the strangle (long) or sell it (short). "The problem with selling strangles, for the customer, is that these have almost unlimited risk," he explains, "and that puts the brokerage firm at a huge risk."

For the most part, margin requirements for retail customers are significant, particularly if the positions these investors are putting on are naked, or uncovered, options, where the investor doesn't have a corresponding position in the underlying stock.

"Our firm has very lenient requirements for naked calls. You need $25,000 in equity, plus the capital risk associated with the trade. Naked puts require $10,000, and that's considered very lenient."

What to do, then? Look to a trade known as the condor, named for the shape of its risk graph on an options strategy chart.

For illustration's sake, we'll use a generic stock as an example.

Stock XYZ is trading at 61 3/8 this month. A customer thinks the stock will close at 60. If he or she wants to sell a straddle, it could look something like this:

Sell the August 62 1/2 calls, trading at, say, 1 1/16 ($106.25 per contract), and the August 57 1/2 puts trading at 5/16 ($31.25), for a total credit of 1 3/8 ($137.50). But without stock, the customer has a naked position, so who knows how much risk he will have?

Besides, many brokers won't let customers sell "naked," so they ask the customer to do something akin to buying the "wings" of a trade. "Think of the trade as one in the shape of a condor," Houston says.

Say you sell those August 62 1/2 calls and 57 1/2 puts -- then you could buy some protection as well.

Buy August 65 calls for 5/8 ($62.50), then buy the August 55 puts for 5/16 ($31.25). That will cost 15/16, or just less than $100. The total cost to the customer is a credit of 7/16 ($43.75) -- by taking in 1 3/8 and spending 15/16.

"That allows the customer to take advantage of what could be a static market with limited risk," Houston says. "The customer can follow his intention -- a strangle type of trade -- but with protection on the upside and the downside."

Psst! It also lets your brokerage firm back your trade and feel comfortable taking the risk.

Volatility Confusion

I have a burning question on an options strategy explained in this week's

Barron's

. The strategy assumes that volatility is going to increase in the near future and that by buying a put and a call on the same stock for the same strike and expiration, whichever way the market goes, you can win from the increase of premiums due to the increase in volatility. Here's the part I don't understand. The strategy includes picking stock with both

low

historic and

TheStreet Recommends

low

implied volatility. I would think that you would look for stocks with

high

historic and

low

implied volatility. Then when the volatility picked up, it would be more likely to return to the norm, which is high, so that the premium will increase a lot. -- Steve Zaslaw

Steve,

You've got the straddle definition down right, except this time the straddles concern options investors can use to play an expected spike in stock-market volatility, which could balloon the price and value of the options.

We consulted Adam Benowitz, onetime options floor trader on the

Philadelphia Stock Exchange

and now head of his own hedge fund. His verdict on picking low-low vs. high-low volatility? "I'm going with the reader; he makes more sense."

Without giving too much space to the competition,

Barron's

quoted an idea on how to play a potential collapse in the market, and the resulting volatility, from options strategist Don Fishback using straddles: "Investors ought to put on trades that will profit from a flurry of volatility in either direction, namely straddles, the simultaneous purchase of both a call and a put on the same stock at the same strike price. Straddles should end up in the black as long as the move in the underlying stock exceeds the combined cost of the call and put."

What Steve noticed, Benowitz points out, is that most options will see their historical volatility "regress to the mean," or return to usual levels. Fishback, he adds, seems to think every option's volatility is going to go through the roof when and if the stock market careens downward.

"It's scattershot logic," Benowitz says. Rather than invest in options with historically low volatility, why now get into

America Online

(AOL)

at a point when it has hit a historically low volatility that is bound to come back?

Secondly, he adds, "I wouldn't buy straddles in this case. All that does is allow the traders to sell more options; it's a fatter trade and commission for them. I would instead selectively buy puts."

Why? "Puts are one of the underrated plays of the last five years because of the go-go stock market," Benowitz explains. "And an even more underrated trade is picking out cheap puts in stocks that have the ability to get crushed."

For example, take October 100 puts and calls on

IBM

(IBM) - Get International Business Machines (IBM) Report

, which trade for 2 ($200 per contract) and 26 ($2,600), respectively.

"For that money, why not just buy 10 times as many puts, if your premise is that the market will get hit? That way, 100 puts will make you more money than 10 straddles."

For retail investors, straddles can be expensive. "First of all, straddles can be sucker bets. When and if the market collapses, of course, that fall will pump up volatility in options prices," Benowitz says. "But why not just buy puts? It's cheaper, safer and less capital intensive since you put less money to work."

TSC Options Forum aims to provide general securities information. Under no circumstances does the information in this column represent a recommendation to buy or sell securities.