The options market is unique in that it allows investors to trade from three perspectives. As an options trader, you can be bullish, bearish or neutral. The first two perspectives can apply to any investment but the latter is unique to options.

When options traders talk about neutral strategies, they are focusing on volatility trading —that is, making a trade based on whether you believe the options are overstating or understating the volatility in the underlying stock. The strategy of choice here is the “straddle.”

The straddle involves the purchase — or sale — of a call and a put on the same underlying security, with the same strike price and expiration date. For example, assume the following prices existed in mid-September:

> XYZ at $50 per share

> XYZ December 50 call at $3

> XYZ December 50 put at $2

If you want to purchase a straddle, you would buy the XYZ September 50 call at $3 and the XYZ September 50 puts at $2 for a net debit of $5 per share ($500 per straddle). The call profits if the stock advances; the put profits if the stock declines.

For the straddle to be profitable at expiration, XYZ has to be above $55 or below $45. So, when buying a straddle, the concern is not in which direction the stock heads; only that it moves dramatically.

This brings us back to the volatility question. Embedded in the options prices is the market’s assumption about future volatility. If you were willing to buy that December 50 straddle against XYZ, then you are really saying that the options market is understating the potential volatility of XYZ over the next three months. If you were willing to sell that December 50 straddle against XYZ, you believe the options market is overstating potential volatility over the next four months.

There is another way of looking at this. Volatility is really defining a trading range for the underlying stock. In this case, the trading range implied by the options premiums is $45-$55 over the next four months.

The implied trading range is very similar to the concept of “implied volatility.” Except, with the implied trading range, you are able to ascertain the value of the options based on some view about the underlying stock. Think about that.

If you are willing to buy the XYZ straddle, are you not also saying that the options on XYZ are cheap relative to your expectations for the stock going forward? That’s important information, and applies to any options strategy you might consider.

Say you are bullish on the prospects for XYZ stock and want to utilize an options strategy to take advantage of that position. You have choices. If you think the options are cheap, then you should simply buy calls. However, if you think the options are overpriced, then you would be better off selling options. The bullish strategy of choice: buy the stock and sell a covered call. Or write a naked put, which is an equivalent strategy to the covered call. If the calls are overpriced, the puts will also be overpriced.

Straddles are an important tool for aggressive investors. They bring another dimension into the decision about which strategy is the best to take advantage of current market conditions by helping you ascertain, in a straightforward manner, whether the price of an option is expensive or relatively cheap.

If investing in stocks isn’t your choice, you could also look at index-based straddles. With indices, you look to buy a straddle when you anticipate a breakout, but are not certain which way the breakout will occur. You sell straddles when you believe the underlying security will remain in a relatively narrow trading range. And, most important, you look at the volatility implied by the options.

If premiums are low — which is what they are now — you would look to buy a straddle. If premi-ums are high, you would look to sell a straddle. When you execute a straddle, you are betting that the options market has either understated (i.e., buy a straddle) or overstated (sell a straddle) volatility.

Of course, you need to make a judgment about what is a reasonable fair value for volatility. For index options, we look to the Chicago Board Options Exchange’s volatility index (symbol: VIX) to provide some insight into how expensive or cheap the options are at a point in time.

@page_break@I like the VIX 200-day moving average as a reasonable proxy for normal volatility. Above the 200-day moving average, index options premiums would be higher than normal; below the 200-day moving average would imply that premiums were lower than normal.

Note from the accompanying chart how index options premiums are currently below their 200-day moving average. Given the time of year — in particular, October through December, during which markets can typically be quite volatile — this may be a good time to look at straddle-buying opportunities.

Some examples include Nasdaq 100 tracking shares (symbol: QQQQ; listed on the American Stock Exchange), which were trading at US$40.45 at the time of writing. At the same time, the QQQQ December 40 calls were trading at US$1.90 and the December 40 puts were at US$1.10. Total cost to buy this straddle would be US$3. For this straddle to be profitable, QQQQ would have to trade above US$43 or below US$37 between now and the December expiration.

You can find the same story with options on the S&P 500 composite index (symbol: SPX) or options on Diamonds, which is the exchange-traded fund for the Dow Jones industrial average.

As always, buying straddles is a speculative strategy. You could lose your entire investment, although with a straddle that is unlikely because the underlying security would have to close at exactly the strike price on the expiration day. Still, only invest with risk capital that you can afford to lose. IE