Explanation

Volatility Trading Strategy:

When trading options based on volatility expectations:

• Buy options when implied volatility < expected volatility (options are undervalued)
• Sell options when implied volatility > expected volatility (options are overvalued)

Analysis of Each Stock:

Stock 1:

• Implied Volatility = 25%
• Expected Volatility = 20%
• Implied > Expected → Options are overpriced → Sell calls

Stock 2:

• Implied Volatility = 30%
• Expected Volatility = 30%
• Implied = Expected → Options are fairly priced → No clear trade

Stock 3:

• Implied Volatility = 22%
• Expected Volatility = 28%
• Implied < Expected → Options are underpriced → Buy calls

Optimal Strategy:

• Sell calls on Stock 1 (overpriced)
• Buy calls on Stock 3 (underpriced)
• No position on Stock 2 (fairly priced)

Correct Answer: C (Sell calls on Stock 1 and buy calls on Stock 3)

This strategy exploits the volatility mispricing by selling overpriced options and buying underpriced options.