Trade Update, Aug 17th, 2012:
BAC has made a 4% move higher since I initiated the long strangle, in line with the market’s strength. With the Sept 8 calls now 0.31 bid, I am going to sell those here with the stock above $8 today, which basically leaves me long the Sept 7 puts for 0.08 each. I still have 5 weeks to expiry on those, which gives me a decent chance to bag a decent winner if volatility in the broader market and BAC in particular picks up between now and then. This move also lowers my total premium at risk on the trade. If we get a move back lower, I will likely sell half of my Sept 7 puts, and potentially buy the call back depending on what volatility does. Trading around the strangle is one way of monetizing the volatility that we originally thought was too cheap.
ACTION: BAC ($8.05) Sold the long Sept 8 call at 0.31. Remain long 2 of the Sept 7 puts (now 0.08 cost base)
-Sold 1 Sept 8 call at 0.31
-Remain long 2 Sept 7 puts at 0.08 cost each (after taking into account 0.08 gain on call sale)
Original Post, Aug 8th, 2012:
We have had our share of ups and downs with our bearish thesis on U.S Financials this year. As of late, we are clearly on the wrong side. At this point we are going to stick to our guns, and believe the next large move is lower, but at the moment, I’d rather find a trade that’s agnostic to direction. I’ve been searching for a single stock that has mispriced volatility. BAC stood out.
Here is the chart of BAC 1 month (white line) and 3 month (orange line) realized volatility over the last 6 months:
So BAC has generally averaged a realized volatility level of 40 to 45 in the past 6 months. That implies a move of about 2.5% per day. The shorter-dated 1 month volatility reading only dipped below 30 for a brief period in May. When I looked at current implied volatility for BAC, the September options are priced at 32 vol for the 8 strike, and 37 vol for the 7 strike, so around a 34-35 implied volatility.
That is below even the shorter-dated 1 month realized volatility level, and basically at the lows of the year. Here is the 1 month implied volatility chart of BAC. Over the last 6 months it has ranged between a high of 57 (corresponding with the June bottom in the market), and the low last week of 31.5:
In this context, I think it’s a very good risk/reward entry for a long volatility trade on BAC that is delta neutral at initiation (in other words, the option structure should not make or lose money on the stock going up or down, but rather on the implied volatility pricing of the options going up or down). But that’s only at initiation. As the stock moves, the delta profile of the structure will change. In essence, I will be rooting for a big move in either direction, so I get long delta as the stock goes up, and short delta as the stock goes down.
Part of the reason why BAC implied volatility is priced so low right now is that the stock has been stuck in a range between $7 and $8 over the last 3 months:
Aside from a 1 month false breakout above $8 in March, the stock has been stuck between $7 and $8 most of the year. As a result, the volatility market has priced in a continuation of this range trade. But that pricing has gotten excessively cheap. My intention is not the hold the following options structure until expiration, but rather trade out of the leg that appreciates based on BAC’s initial move higher or lower, and then look to maximize the other leg of the trade.
Trade: BAC ($7.72) Bought 1 of the Sept 8 call and 2 of the Sept 7 Puts for $0.47 total
Bought 1 Sept 8 call for .23
Bought 2 Sept 7 puts for 0.12 each, or 0.24 total
Break-Even on Sept Expiration:
-Profits above $8.47 and below $6.76
-Losses of up to 0.47 between 8.45 and 8.00 and 6.77 and 7.00, max loss of 0.47 between 7 and 8.
Quick note on break-evens – the downside break-even is closer to 7 than the upside break-even is to 8 because I am long 2 puts vs. 1 call.
This is not the type of trade that makes sense to hold to expiration in most cases. Rather, the idea is to wait for the implied volatility to reprice higher and get out of the trade at that point. I bought 2 puts against 1 call because that makes the trade delta neutral at the start, so the structure should change value equally if BAC goes up or down.