An options price is determined by a variety of factors, but volatility, the amount an underlying stock's price is expected to move, is one of the most important factors to consider when trading options. If a stock is highly volatile, there is a greater chance that it will reach the option's strike price. With low-priced, high-volatility stocks, we can often trade inexpensive at-the-money options to take advantage of low-risk trading opportunities based on volatility rather than price.
Bank of America (NYSE: BAC) is a low-priced stock (under $10) that has traded with a high amount of volatility during the past year. In the past 15 weeks, BAC is up more than 30%. That reversed a 32% decline in the previous 11 weeks. In the 15 weeks prior to that, BAC was up 105% after falling 30% in 13 weeks.
BAC's history of volatility is well established, and given this, I would expect options to price in a move of at least 25%-30% over the next four months. But the January 2013 options seem to be under pricing a large price move in BAC. We have about 16 weeks until the January options expire and at-the-money options are priced to breakeven with relatively small moves in BAC.
A January $9 call is trading at about $0.80 at the time of this writing. Based on Monday's closing price of $9.11, that call is profitable if BAC moves up by at least 9%. The January $9 put is trading at about $0.70 and is profitable if BAC falls by 9% or more. Based on history, we are likely to see a double-digit percentage move in BAC over the next four months, and that could provide profits for traders holding one or both of these options.
Rather than attempting to pick a direction for the expected price move, we can buy calls to profit if prices rise and puts to profit from a price decline. The purchase of both a call and a put would cost about $1.50. Buying both a call and a put in the same stock with the same expiration date and the same strike price is known as a straddle trade. With this trade, we profit from an increase in volatility no matter which direction the stock price moves.
If BAC goes up 20%, the stock would reach a price of $10.93 and the call option would be worth at least $1.93 (a 29% profit on the combined purchase price if the put expires worthless). If BAC falls to $7.28, a 20% decline, the put would be worth at least $1.72 (a 15% profit if the call expires worthless). Based on the recent past, there is a high probability that one of these options should reach their target price. It is even possible, but unlikely, that both options could reach their target.
The loss on this trade is limited to the purchase cost of the two options if BAC remains trading at $9 a share. If BAC closes above or below $9 a share when the options expire in January, the loss would be less than that.
Action to Take --> Buy one BAC Jan 9 Call and one BAC Jan 9 Put for a combined purchase price of $1.60 or less. Do not use a stop-loss. Set a price target of $1.93 on the call option and $1.72 on the put option.
This article originally appeared on TradingAuthority.com: