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Answer: Sell calls on Stock 1 and buy calls on Stock 3
## 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.
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An options trader gathers the following data for 1-year call options on three stocks:
| Stock | Implied Volatility | Trader's Expected Volatility |
|---|---|---|
| Stock 1 | 25% | 20% |
| Stock 2 | 30% | 30% |
| Stock 3 | 22% | 28% |
Based only on this information, which of the following actions is most appropriate for the trader?
A
Buy calls on Stock 2
B
Buy calls on Stock 1 and sell calls on Stock 3
C
Sell calls on Stock 1 and buy calls on Stock 3