Staying on our topic of reader questions on option trading, there's a particular strategy we'd like to look at today that doesn't even require you to correctly predict the market's next direction.  Now may be a good time to consider the "straddle" options strategy.

Question: Will the straddle work or even make sense with index options like OEX? I'd given up on individual stocks and have been trading OEX options exclusively for a few months now. I notice that, except for the price of the premiums, it seems to make little difference in volatility, etc. if I buy the OEX options in or out of the money, so I buy them out of the money for the cheaper premiums. I remember reading about straddles and spreads once, and correct me if I'm wrong but the behavior of options on individual stocks seems to depend on whether they are in or out of the money, and I thought that was the key to straddle/spread strategies. Am I correct in thinking that these strategies won't work for index options? If not are there similar strategies that can be employed that do work to hedge risk and "make money both ways" with index options like for OEX?  Submitted by Bill C.

Answer: First, here's how a straddle works.  Let's say XYZ shares are trading at 50 and you expect the stock to be volatile, up to the 60 area of higher or down to 40 or lower over the next several months.  The only issue is that you don't know which way it's going to move first.  The straddle purchase is an option strategy which can get you on board the start of a big move.

By purchasing both the 6-month XYZ 50 call and simultaneously buying the 6-month XYZ 50 Put, we now have a position that can benefit as long as XYZ shares are volatile as predicted.  When you buy the same strike price on both sides, it's known as a straddle.  If the strike prices are different, it's called a strangle.  The key to success in buying straddles is what you pay for the call and put option, relative to the volatility which actually occurs. There are several factors to consider in getting the cheapest straddles which can offer the greatest leverage in a potential volatile move:

1. Time Decay - When we buy an at-the money straddle (where the strike prices of the call and put are roughly equal to the stock's price), we are buying all time premium on both sides of the market.  That means that if the stock does not move very quickly in either direction, then our decay rate of the options will accelerate as we get closer to options expiration.  As a result, you don't want to be a buyer of options with 1-2 months before their expiration.  The time decay is simply too great to overcome.  But if you buy options with 4-6 months of time remaining, the premium lost in the first month will not be as dramatic if you have to wait initially before the anticipated big move occurs. 

2. Current Volatility compared to Historical Volatility - You don't want to buy a straddle on a stock that is currently near its highest ever volatility, as the risk is too great that the stock will become less volatile and the options premiums on both sides will collapse.  You want a tool to tell you the percentage ranking (0% being low and 100% being high) of the stock's current volatility compared to its historical volatility.  Larry McMillan's website www.optionstrategist.com has a nice volatility calculator which can tell you the volatility percentage ranking, so you can make sure to buy your options when they are historically cheap.

3. Volatility Can Behave Differently on the Way Down vs. the Way Up - Typically the volatility in a stock's options will be priced higher as the stock drops.  But as the stock trends higher, I have often seen the stock's volatility stay stable or even go down well into a steady rally.  So you may want to be more careful about putting on straddles after a meaningful decline, which being ready to jump on steady uptrends when you think they appear to be peaking out.

Answering Bill's question more specifically now, I prefer to buy straddles on individual stocks instead of the indexes.  With 100 to 500 stocks in an index, it makes the really volatile movement in the index less likely than the individual component stocks that make up the index.  As a result, my favorite options strategy for the indexes tends to be the credit spread (which I'll discuss in more detail later this week).  I've often found that the index does not move as far in either direction as the volatility would suggest.  This makes for a better situation selling options instead of buying them.

With the CBOE Volatility Index (VIX) currently hanging around the 12% level, that's a relatively low reading in the last several years.  So with earnings season here, I encourage you to look for stocks which should be volatile but their total premiums are still attractive. I generally would like to be able to at least double my total investment in a straddle to justify the capital risk.  Another strategy is to sell one side when that side hits a 50% loss and seek to let the other side run (assuming that remaining side is still profitable).  So you can convert a non-directional strategy like a straddle into a directional play once the trend starts to assert itself.

Price Headley is the founder and chief analyst of BigTrends.com.