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Introduction

At its price of $33.82 (closing price from yesterday), Frontline Ltd. (NYSE:FRO) looks cheap on a valuation basis. The day-rates on both the VLCC and Suezmax ships are well above FRO’s breakeven and after the economic slow down the rates seem to be increasing. With 82 ships (and another 7 to come online within 2 years) FRO has the luxury to use a good portion of their fleet as floating storage. Moreover, all but four of their ships are double hulled. With the phase-out of single hulled ships, FRO is well placed.

But today’s article is not about going long FRO, it’s about playing the stock’s volatility.

Show me the Volatility

Looking at a chart (below) of the S&P 500 and FRO we see that although FRO has been drifting upward it has done so with a lot of volatility. It goes up a little than pulls back and repeats the process.

click to enlarge

Chart comparing FRO and the S&P index

(price chart of the S&P 500 and FRO from Jan. 1 2009 until June 24th, 2010)

In fact, the S&P has a daily volatility (as measured by the root of the variance of the price movements) of 1.6% while the volatility of FRO is more than double that at 3.9%. On an annualized basis that is 25% and 62% volatility respectively.

If we look at the near term July 17th calls on FRO (assuming a 4.5% interest rate and a 7% dividend yield) we see that the option is pricing in (an implied) annual volatility of 44.25%. The options are pricing a significantly lower volatility than what the stock has actually seen. As the value of an option increases as the volatility increases, this fact may suggest that the options are undervalued.

The strategy

Based on this factor the options on FRO are cheap and under pricing the stock's recent volatility; therefore it is cheap to buy volatility on this stock. This can be accomplished through the use of a straddle, buying an at the money call and an at the money put. This strategy will cost you some money up front, but if the stock moves (in any direction), as it has done in the past, you can make signification gains.

In this strategy you would buy the July calls with a strike of $32.5 for $2 and buy the July puts with a strike of $32.50 for $1.10. The total cost to you is $3.10, meaning if the stock moves to $35.60 or $29.40 you’ll be making money. Given that the stock has recently been moving in a band from about $29.00-38.00 there is a good chance that you’ll have a positive return by following this strategy.

FRO Straddle

(The dark black line shows the combined pay-off of the straddle strategy, while the blue line shows the pay off of the call, and the yellow line shows the put’s payoff)

Based on the above, if FRO drops by 13% or increases by about 5% the straddle strategy will payoff. Normal CurveAs noted above there are 17 days left before the July options expire. Based on my calculation, the average return of FRO over 17 days (from January 1, 2009 until now) is 0.2% while the standard deviation is .1593. Assuming a normal distribution of returns, there is about a 58% chance that this strategy will be profitable.

Up the Profits.

By converting the straddle into something like a butterfly, by shorting an out of the money put and an out of the money call (for this example I’ll be looking at the July puts with a strike of $27.5 and July calls with a strike of 37.5) the upside of the strategy is capped (at $2.6), but the cost to enter the strategy is reduced by $0.70 (for a total cost of $2.4). This means that the strategy is profitable if FRO’s share price decreases to $30.1 or $34.9.

FRO Butterfly

Based on the normal curve, there is about a 66.5% chance that this trade will be profitable.

A Word of Caution

If the volatility does not materialize, and the price of FRO does not move from out of these bands you’ll end up having nothing to show for your investments. As always, options can ramp up your returns, but can also ramp up your losses.

If you are nervous about using options, then consider buying FRO near the bottom of the range (around $30-$31.5) and selling it near the top of the range (around $36-$37) for a tidy 14% gain.

Disclosure: I am considering putting back my long position in FRO.

Source: Playing Frontline's Volatility