The Joy of Straddles

And some answers on spreads, volatility and open interest.
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Breathe the word "Internet" over even the most old-fashioned stock, and suddenly it tastes like someone added accelerant to the brew.

Even old Ma Bell isn't exempt.

AT&T

(T) - Get Report

, according to one options investor, "isn't just a telephone company. It's now an Internet play."

Wow, that was fast.

But let's take on the real, red-hot Internet stocks:

America Online

(AOL)

,

Yahoo!

(YHOO)

and

Amazon.com

(AMZN) - Get Report

. But since instant gains don't seem as easy to grab as they did a few months back, it may be time to actually start trading options on these beasts. The next question is: How?

In this Options Forum, we'll tackle what are known as straddles, especially straddles on Internet stock options, which have been in hot demand these days. A straddle, by way of Larry McMillan's always-helpful reference book,

Options As a Strategic Investment

, is the purchase or sale of an equal number of put options and call options having the same terms.

Also, we'll touch on the basic, but ever-important, question of open interest on options contracts, answering a question from one reader who wants to understand how to track open interest increases or decreases.

Keep sending your questions to

optionsforum@thestreet.com, and, hey, include your full name.

Counting Open Interest

I have a question regarding open interest on option contracts. I know that if I buy, say, 10 calls at a certain strike and expiration to open a position on stock XYZ Corp., then the open interest for that contract will be increased by 10. But what if someone else later opens a position by selling 10 XYZ calls, with the same strike and expiration as the 10 calls that I bought? Will the open interest also be increased by 10, or will the open interest be decreased by 10 since their sale will have effectively cancelled my purchase? -- Wade Luther

Wade,

When you look at the open interest on an option, what you're really seeing is the number of open, long positions investors are holding, according to George Fontanills, president of

Pinnacle Investments

in Boston, Mass., and an options trading expert.

Fontanills explains it this way: "For every buyer there's a seller. There are 10 contracts, but there's a long and a short to every position. If you go ahead and buy 10 call options, that means someone sold you 10 options against that position. You're long, they're short. But there are only 10 contracts, or transactions, if you want to look at it that way.

"For argument's sake, let's say there are only two people in the market: you and me. You decide to buy 10 calls on XYZ. I sell them to you. Right now there are 10 open contracts. Let's say you and I are still the only people on the market, and you decide to sell. I'm the buyer. We're back to zero. Of course, that's a vacuum, not the real world. There are hundreds and thousands of buyers and sellers.

"So, really, the best way to look at open interest is just how many trades went out on the long side."

Price Fix Solution

A few weeks ago,

BusinessWeek

had a feature concerning options price fixing on the American Stock Exchange. Based on the information in that article, I'm wondering when I put orders in, exactly what price should I use. Example: My broker says 1 3/4 to 2 but on the floor it might really be 1 13/16 to 1 15/16. Any good ideas on how to put orders in would be greatly appreciated. -- David D. Mansius

David,

First off, we're big fans of

BusinessWeek

, and its article on the Amex was interesting.

Buuuuuuuuut, price fixing or not, the average investor needs to first make one key decision about his options trade, and that is: What is more important, the execution of the trade or the price? If the execution is of paramount importance -- meaning that you want to get into play no matter what the spread is -- you can.

If you're more price-sensitive, you can enter your order at a specific price and wait until it is met, thus insulating yourself from any exchange floor shenanigans. Either way, in an ideal world, the broker representing your order in the pit is obligated to do the best he can, price-wise, on your behalf.

Depending on the stocks you're playing via the options market, spreads that may seem too wide may simply be reflecting extreme volatility or illiquid markets. If you see a spread of 3/4 between the bid/ask, usually the case is that getting stock to hedge is more difficult. "Market makers don't know where they can get stock and they price the bid/offer accordingly," says John Power of the

Options Institute

.

Volatility Basics

I do not actively trade options yet, but I would like to. Unfortunately, I do not have access to good enough information to trade options properly. But I would like to ask you a technical question about stock options. Normally, how does the implied volatility of an option compare with the historical volatility of a stock? Is the implied volatility indicative of what the current volatility of the underlying stock is over the past day or over the past 10 days or the past month? More or less, I am specifically talking about Internet and tech stock options. The reason I am asking is I would like to try to time my option purchases to when the implied volatility of the stock option is low. When the implied volatility is extremely high, I end up paying a huge premium for the option. -- Samuel Cheng

Samuel,

Buy low, sell high. That works for us. In the case of volatility, though, it may be more difficult to time.

The implied volatility levels of options on tech and Net stocks is higher than most other sectors on a consistent basis. Because implied volatility is a factor in an option's premium, it can be adjusted by traders if they see unusual order flow in one direction, and that's what causes the high premiums you mention.

The theoretical value of an option -- its fair price depending on time, interest rates, intrinsic value, yadda, yadda, yadda -- depends on future volatility of the stock, which cannot be precisely known.

But according to

Options As a Strategic Investment

, "even though XYZ stock may be exhibiting the same historic movement that it always has, and therefore its historical volatility would be unchanged, if options buyers appear in sufficient quantity, they may drive the implied volatility of XYZ's options higher." Whew!

Most stocks' implied volatility levels rise when earnings approach, so unless you want to play for a day or so, stay away from trading during those times. Buying into high implied volatility levels can be lucrative if some type of takeover or other news hits the stock hard enough to move it drastically in either direction. But, as volumes rise, you can be a target for sellers of options who may be experienced enough to sell high and buy the options back when volatility comes in.

Otherwise, take a look at Larry McMillan's

site, where he has a host of statistics on both implied and historical volatility.

Straddling the Net

What is your opinion about straddles? With reference to the Net stocks (Yahoo!, AOL, etc.) that are extremely volatile, isn't it good strategy to use straddles? It is not easy to find out where those stocks will move in the immediate future, but it is easier to tell they will go somewhere. Could you please provide some straddle examples on the basis of a current quotation of AOL? (How much is the straddle today, and what is the minimum price movement needed to get the profit?) -- Anton Outchitel

Anton,

Excellent question. Once again, we kick the ball out to George Fontanills, who points out that the historical and implied volatility of an option both play a critical role in deciding whether to put on an Internet stock option

straddle

.

To start off, Internet stock prices' extreme swings lead to increased volatility, and that significantly affects the way options are priced.

"Traditional buy-and-hold investors may find these increased volatility levels to be confusing," Fontanills says. "However, there are a variety of options strategies to take advantage of high volatility."

If the implied volatility -- or the volatility in the pricing of the options -- is higher than the historical, then buying a straddle is not a good idea, he adds. "I usually try to wait until the implied volatility is at the low end of the range and then buy a straddle." (You can find out the volatility figures either through your broker or from options Web sites, such as

Fontanills' or McMillan's

site.)

One warning, though. Fontanills says he does not buy straddles with 30 days or less to go until expiration. "That's throwing money away."

For example, right now AOL is at the high range of volatility and has been trading in a wide price range.

If you place a straddle today for AOL with an at-the-money May 120 call and May 120 put, you will pay roughly 18 1/4 ($1,825 per contract), he points out. "You need a really big move to make money with only a few weeks to expiration for the stock to close above 138 or below 102. And that's just to break even. Not a good bet."

That's not to say it can't happen, but why let time work against you?

To make matters worse, AOL right now is on the high end of the volatility curve, and if that volatility drops, the straddle will lose value also. So you lose again.

What to do? Wait for AOL to be at the low end of volatility (again, check with the appropriate source for volatility figures), he says. Then consider buying a straddle with at least 90 days to expiration.

Fontanills says he did this successfully just a few months ago "because I allowed myself time to be right and bought the straddle when volatility was low. As the stock started to move I made money on the price movement, as well as on the increase in volatility. You will have a better chance to win. I can't tell you when this will happen, but be patient. Straddle trading is great for those who know the rules."

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