Take Advantage of Volatility in Blue Chips

SUMMERTIME IS SUPPOSED to be slow and listless, and yet some all-season trading opportunities are emerging for some widely held stocks.

The implied volatilities of Anheuser-Busch (BUD: 51.66, +0.23, +0.5%), General Electric (GE: 38.47, -0.23, -0.6%), Coca-Cola (KO: 52.89, -0.01, -0.0%), Pepsi (PEP: 65.87, +0.28, +0.4%), Target (TGT: 63.66, +0.40, +0.6%), Time Warner (TWX: 21.13, -0.28, -1.3%) and United Technologies (UTX: 72.68, +0.21, +0.3%) are unusually expensive compared with their realized volatilities, according to Andrew Wolchek, an equity-derivatives strategist at Citigroup.

These stocks have realized average 14.6% volatility over the last three months and 15.1% volatility over the last three years. However, the average three-month at-the-money implied volatility for the group is 18.7%, which is a 3.6 volatility point, or roughly 25% premium over three-year historical volatility, he said.

"We suggest selling volatility on each of these stocks and would expect volatility traders to realize a significant portion of the 25% premium of implied to historical volatility," Wolchek says.

Institutional investors will undoubtedly take advantage of this with complex trading strategies, including selling volatility using variance swaps or by delta hedging short straddles/strangles that are near-the-money.

But such complexities are not within the reach of most investors. Wolchek says individual investors should consider overwriting their stock positions with expensive call options or replacing long stock positions with short put positions.

Here's Citigroup's take on highlighted stocks, all of which have unusually high implied volatility levels, which suggests opportunities — and incumbent risks — for investors bold enough to sell options.

These volatility snapshots read like a hodgepodge of numbers, but try not to be put off. In options-land, the consensus view is that volatility, which is the most important factor of an options price, behaves like a rubber band — stretching in response to demands and emotions of the marketplace. Volatility, they say, behaves like a rubber band, and when it is too high, as it is in the stocks in Citigroup's list, volatility snaps back.

The risk to these trades — and it is a real risk — is that no one can predict just when volatility may snap back. So while these trades may seem appealing to many investors, understand that they are risky, and they are not for everyone. Anyone who trades options must manage their positions. You cannot simply buy and hold like in stocks.

In fact, Citigroup recommendations are limited to certain months, rather than strikes. Investors should choose the strikes of options they wish to sell based on their own comfort levels or goals. Most investors tend to sell slightly out-of-the-money call and put options against long stock. When selling puts, investors usually look for premiums of a dollar or more. When selling calls, investors usually look for premiums big enough to justify the possibility that the stock could get called away.

BUD: Rumors of a leveraged buyout have increased implied volatility to a three-year high. Citigroup recommends selling August options to benefit from this anomaly. The trade will be profitable if volatility decreases, which will occur if the market concludes the LBO rumor is nothing more than rumor.

GE: The implied volatility of options that expire in three months is at a 15% premium to historic volatility. The uptick has followed some good press for the company, and also reflects a growing consensus in the market that large-cap stocks will lead the next leg of the rally, as they are better able to weather interest rate uncertainty, and also offer more exposure to fast-growing international markets. (See "Summertime Options Strategies" for more information about this market trend.)

KO: For the first time since 2004, Coke's options are registering implied volatility that is 29% higher than historic volatility. Coke is also considered an LBO target, even if it is unlikely. (We talked about the LBO speculation last month.

PEP: Implied volatility is increasing even as historic volatility decreases. Such is the dichotomy between the market's expectations and the stock's actual performance. Pepsi's three-month implied volatility is 15%, compared with average historical volatility of 12.8% during the past three years.

UTX: Three-month implied volatility is trading at a 51%, or 6.3 volatility-point premium to three-month historical volatility.

Trade recommendation for GE/KO/PEP/UTX: Citigroup recommends selling long-term options because they are more expensive than short-term contracts. The risk is that investors are effectively short for a longer time period.

TGT: Three-month implied volatility is increasing even as realized volatility decreases. Three-month implied volatility is at a 51%, or an 8.5 volatility-point premium, to three-month historical volatility. Implied volatility peaks among options that expire in October so Citigroup recommends selling contracts from that expiration.

TWX: Three-month implied volatility is at 14%, or a 2.5 volatility-premium to three-month historical volatility. To benefit from this, Citigroup recommends selling January options.