Wed May 9, 2007: Option Income Straddle Yielding 50% on IOC

The stock of InterOil Corp. (AMEX-IOC) closed today at $29.64 per share.

Writing a June 30 option straddle on this volatile stock currently offers a return of 50% by selling ("writing") an option combination of both the June 30 call and the June 30 put, assuming that the stock remains unchanged in price.

Let's see how this return is calculated.

The total income per straddle on 100 shares is $780 because the call can be sold for 3.70 and the put for 4.10. The in-the-money amount is $36 (30.00 - 29.64, times $100) so the net premium income ignoring commissions is $744.

Assume a margin requirement of 50% of the strike price, or $1,500 per straddle. Actual margin requirements may be lower depending on your brokerage firm, but by using this amount we're likely to have enough set aside to meet the margin requirement for holding 100 shares either short or long in our margin account after expiration if we let one of the options be assigned to us, as we'll discuss below.

$744 divided by $1,500 is approximately 50%. Remember that this assumes the stock remains unchanged. In all likelihood, this will not be the case. The interesting part of writing straddles is handling the expiration.

We'll consider each of two possibilities. On expiration day, Friday June 15th, either the stock finishes above 30, or below 30.

Quiz: What are the break-even points for this trade? (answer below)

If it's above 30, the call buyer will exercise their option to buy ("call") from you 100 shares of IOC at $30 per share, which your broker will automatically sell short for you in your account. Note that if no shares are available for shorting within a few days (unlikely but it does happen sometimes) you'll be required to buy back the stock ("cover your short") even if that means you take a big loss if the stock has gone up a lot above 30. As discussed in a previous commentary, if you really wanted to stay short in this situation you could of course put on a synthetic short at this point. You could also sell covered puts.

If it's below 30, the put buyer will exercise their option to sell ("put") to you 100 shares of IOC at $30 per share, which your broker will automatically buy for you in your account. Then if you'd like you could write a covered call for a subsequent month, or you could write ratio calls.

In both cases, the $780 option income is yours to keep. Of course if the stock swings outside the break-even points you'll have a net loss at that time.

Please discuss with your financial advisor all the risks of the type of strategy described here.

Until next time, best of luck with your option investments!

Quiz answer: 22.20 and 37.80