Volatile Enough For You
So what did we learn last week?
How about yet another example of why shorting incredibly pumped volatility rarely works. Here’s FNM’s chart for the last 
week, and that was the less volatile GSE.
Here’s what I had to say the other day.
Free Money Idea
Sell the FNM July 15 straddle for $4.
Yes, that’s $4 for a straddle with a strike price of 15. With 2 weeks to go. That translates into something like a 180 volatility. Don’t they have government guarantees or something? Free cheese!
OK, hoping the sarcasm above is obvious.
That’s some monster price of course, wow. The best thing you can do when something goes on tilt like this is just avoid it. The next best thing is to use spreads. Either calendars or a directional bet via a vertical. The worst thing idea is just sell gamma and cross your fingers and hope for the best. It may work out, but volatility explosions do not happen in a vacuum.
I can’t emphasize that point strongly enough. Conventional wisdom says you actually buy gamma in the near month when this happens. And obviously hindsight is 20/20 and it would have worked here, and in Freddie. But that’s a game better left to the floor traders. I wouldn’t open a position like that off-floor and bank on my ability to handle 180 volatility. And I wouldn’t advise anyone to try it unless they were very comfortable with the VERY active trading it would take to manage such a position.
What about calendars? Obviously there’s a huge volatility premium in the nearer month’s. Well, conventional wisdom says you actually want to sell calendars when this happens. The theory being you can trade stock against the long gamma of that position, meanwhile the longer dated options are overpriced in volatility terms as this sort of trading tends to dissipate within a couple weeks.
Again, I wouldn’t try that at home either, but also would resist the temptation to buy calendars at what look like great prices. I should have noted that the other day when I threw the calendar idea out there.
Vertical spreads probably make the most sense. It involves making a directional bet, but that’s got defined risk, and avoids making what could be a disastrously wrong guess on what will happen to volatility.
July 14th, 2008 at 1:46 pm
Hi Adam:
can you please explain why the puts of FRE are not bahaving well enough. Both July and August 7.5 puts are not moving as much as the stock. FRE is down 11% and -FRESU (July 7.5 puts) are down 17%. I know that the July options have lost some tiome value but I do not understand why they are not moving fast enough like the stock. Did volatility decrease? Is it manipulated by the market makers?
July 14th, 2008 at 1:50 pm
Volatility was insane the other day, almost incalculable. So all you’re really seeing is a decrease in volatility. To some extent, the “news” is out. At least this latest round of news, obviously the story is far from done.
And no, market makers can not realististically manipulate option prices beyond like a closing quote. It’s a wide open market. If they are a steal now, the world will come in and buy them.