Trade idea: take advantage of the low-volatility environment with a butterfly strategy

After breaking several all-time highs the US indices are now poised to move higher with less and less volatility. Good news coming from the job market and retail sales is welcome with a sudden decrease in implied volatility and low levels of realized volatility, but with limited moves in stock prices. The current environment is therefore more interesting to play from a volatility standpoint. Stocks display very little volatility in their way up, in line with the empirically observed inverse relationship between stock prices and (realized) volatility that motivated the financial researcher to develop the local volatility model (E. Derman (1995)). This can be visualized just by looking at the dynamic of the US indices between the year 2009 and the current date.

We choose Best Buy, the US retailer, as our candidate for this strategy. Best Buy moved sharply higher following positive results, better-than-expected retail sales numbers and a boost from Citigroup’s equity research department. The strategy is to play the low-volatility environment with a low-theta option strategy.

Our recommendation is to build a skewed butterfly around the $22 level, i.e. buy a 20 strike call option, a 25 strike call and sell two 21 strike calls. The strategy allows to secure a constant gain of $0.72 should the stock move below the $20 level, a variable gain between $20 and $22.72 that peaks at $1.72, and a constant small loss above $25. Between the current stock level and the $22.72 level, a volume barrier is likely to prevent any quick surge. We are considering BBY options expiring at close May 17, 2013.


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