Steve:

I have a quick question on a short strangle. If you sell in-the-money calls, what are you stuck with at expiration, and how do you resolve it? It would seem that your account would be debited for the buy (from the puts) and you'd also have short stock from the sale of the calls. Is this correct? I'm trying to get around the spreads which turn my position into an unprofitable one. Thanks,

-- H.

Because the technical definition of a strangle position typically involves the simultaneous buying or selling of out-of-the money puts and calls on a one-to-one basis, I initially assumed that the reader was perhaps a little confused, and I first responded by explaining that in a strangle either the puts or the calls can be assigned, but not both.

But follow-up emails clarified that both sides of the reader's strangle were actually in the money. Without getting into all of the details, what happened was that his current position wasn't his original intention (the initial trade was simply shorting some put options), but rather resulted from an adjustment made in an attempt to minimize the potential loss due to a decline in the underlying stock price.

Generally speaking, most investors should be very selective and show restraint when adjusting positions; sometimes it's better to just close out the position rather than embark on a salvation project that requires additional transactions. This is because every new strike added to the existing position is an additional component that requires monitoring and represents another element that can go wrong. Too many adjustments or pieces can tangle a position to the point at which you no longer know what you have or what you want to happen.

That said, in selling some in-the-money calls against his short puts, the reader has kept his adjustments to a minimum and the position fairly simple. What he has done is gain some downside protection for his short puts if the share price keeps falling, and he can capture whatever time premium was remaining in the options. However, the risk here is that if the stock rallies sharply, he'll find himself with a negative delta, and will lose money on the short side of a stock in which he was originally bullish.

As far as extricating yourself from the position, assuming that each side remains in the money, both the puts and calls will likely be assigned. The long and short share assignment will offset each other, resulting in a net flat or no stockholding position. Holding the position until expiration and accepting the assignment will certainly save you the aggravation and costs, including the bid/ask spread (which can be quite wide in some cases) associated with closing the position through a market transaction. Look at this article for the rules governing option exercise and assignment .

Steve:

How would you determine the following? At the close today, an INTC July put at the $25 strike was priced at 25 cents. After hours, INTC was trading around $24.90. If INTC were to open tomorrow at that level, at what level would you likely expect the July $25 put to open, and how is that calculated? Thanks,

-- N.S.

This question was received on Tuesday, and after the close of trading on that day Intel ( INTC) reported relatively disappointing second-quarter earnings results. The next day, its shares opened at $24 and traded as low as $23.25. In trying to divine what value should be assigned to the July 25 put, it helps to use an option calculator , such as the one found on the Chicago Board of Options Exchange Web site.

As always, implied volatility will be the unknown and the key element in predicting an option's future price. In this case, we can start with the known elements: Given that on Tuesday the shares closed at $26.14 and there were three days remaining until expiration, if the July $25 put were trading at 25 cents a contract, the implied volatility would be about 71.5%. This is a very rich number considering that average implied volatility for Intel's near-term options had been 35% during the preceding 30-day period.

If Intel had opened at $24.90 the next day, and assigning an implied volatility of 50% (this is just my guess, because you could expect -- regardless of the outcome -- that the implied volatility would experience some postearnings compression), the July $25 put could be forecast to have an approximate value of 50 cents a contract. Again, this is based on trying to predict what the implied volatility might be at that point in time. Currently, Intel's August options are being assigned an implied volatility in the 32% to 35% range.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to steve.smith@thestreet.com.