Wow, volatility sure is low. Even though the VIX has recently moved up from the low to mid teens, to most traders and investors it seems like years ago that it was over 40. With volatility low in the broader indexes, and exchange traded funds like SPY that track them, most short-term traders have been forced to find specific stocks where volatility levels are still elevated.
While most major equity markets have moved higher during the now six month rally, obviously, a number of stocks are still very volatile. Indeed, despite the big move in technology stocks, two of the more volatile stocks today remain Apple (AAPL) and Baidu (BIDU).
Baidu is an interesting stock. While the company's shares have routinely rallied and sold-off more than 30% in just several months time, Baidu shares have stayed within a fairly tight range over the last 5-6 months. While I recommended a longer-term trading strategy for getting long the stock when Baidu shares were in the low 130s, and recommended a more leveraged long position after the company's earnings report, I think the options market today is setting up a nice short-term strategy. Let's look at the chart.
{Chart from thestreet.com}
As we can see, while BIDU is certainly more volatile than most stocks, the Chinese search engine's shares have generally still stayed within a relatively narrow range of $125 and $145 a share.
However, while Baidu shares do not appear overly volatile on an extended basis, the company's share are still very volatile during most days and weeks. There are many possible reasons for why this is, but I think two major reasons are how volatile the Chinese equity market continues to be since growth in Asia continues to be below expectations, and because estimates for the company's long-term growth prospects vary widely.
What is interesting to me from a trading perspective is that despite the fairly narrow range BIDU shares have traded within for the last six months, the volatility premiums in the stock's call and put options are still very high. With the put to call ratio at .6 to 1 and implied volatility levels in the company's options trading at 30% above their 30 day average of 27%, I think shorting the company's front month calls with a covered call strategy is a good short-term trade here.
I would simply buy the stock and continue to short the front month calls until the implied volatility levels drop to around their historical range of 25-30%. Here is how the trade would work today: A trader or investor could purchase 100 shares of BIDU at approximately $145 a share or buy the 100 dollar April call option for right around 45 dollars and sell the 145 dollar call option that expires in 2 weeks for 4 dollars. This strategy enables a trader or investor to get a 3% a month return if the stock simply holds its value.
I would buy back the call anytime that the option declined by more than 75%, and resell the call anytime the stock went up by more than 2%. This strategy enables traders or investors who don't mind being long BIDU longer-term to net a 5% monthly return without taking excessive risk.
Obviously, in the worst case scenario, if the stock were to decline more in a month than the amount the individual collected from selling the call option, you would own Baidu shares with a cost basis at around the 140 dollar level. If you are a bull on Baidu, as I am, detailing the reasons at length in a previously written article, owning Baidu shares with the stock priced at around 22-23x the average estimate of next year's earnings should be appealing anyways.
For traders who want to take less risk they could simply short monthly call spreads or sell monthly calls against calls going out six months or longer that are deep in the money. An example of this would be buying the 100 dollar September call for around 50 dollars and selling the front month call in April at the 145 dollar strike of nearly 4 dollars. Obviously, traders and investors who have differing views on Baidu and varying risk tolerance levels may want to apply a trade differently.
To conclude, while volatility levels in the broader indexes remain at the lowest levels we've seen these indicators at in several years, the high levels of bullishness we see today in momentum stock like BIDU and Apple is leading to higher than average volatility premiums in these company's call options.
While shorting the market has been a losing strategy for many traders during the last six months, there are still fairly low risk ways to take advantage of the sell-offs we are beginning to see occur more frequently.
Disclosure: I am long BIDU.
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