So what did we learn this week?
How about yet another example of why shorting incredibly pumped volatility rarely works. Here's FNM's chart for the 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.
12 comments:
Selling ATM calendar spreads into surging IV is a sound investment idea.
But it takes nerves of steel. If that front month option fades away with time, and if IV remains high, you may have a substantial loss (unless the stock price changes by a bunch, shrinking the calendar spread).
Adam, ran some sims with a both sides of a Jul/Aug calendar starting off with 3 contracts on the $5 puts to 1 contract on the $10 calls -- a setup which would begin the trade at delta neutral.
The back month implied vol on the 5 put is 380; the implied vol on the 10 call is 322.
If you buy the spread, and back month vols stay constant, your profit probability is over 90%, and you sweet spot is somewhere between 3.50 and 17. At the peak of the curve, you would basically double your money in one week.
If you buy the spread, and back months lose half of their volatility, you will basically lose all of your money.
If you sell the spread, and back months lose half of their volatility, you will ONLY lose money if the stock ends betwen 4.70 and 5.70, and then you won't lose much.
However, if you sell the spread, and back months retain their volatility, you will almost certainly lose money, as the stock has to fall below 3.50 or above 17.00 for you to turn a profit.
Moral of the story?? It's all about the back months, and how fast they give up their volatility.
So, if you make this trade, either side you are guessing -- that's right, guessing -- about the progression of the vols on those August contracts.
yeah, whole lots of moving parts playing these. But you hit on the general issue, the crapshoot that is longer dated options with spiked volatility. The hard thing to "model" is how well you would do trading your gamma in the next week.
I'm just staying away.
I gotta tell ya, having done the sims, it is tempting to go short gamma. Huge upside return possibilities for not a lot of capital at risk -- and you can set your stops at vol drops, not price.
The only thing that could throw a monkey wrench into this is the Fed backstopping or Treasury bailing.
But my understanding is that FNM could actually let assets run off and free up cash flow to take write downs. The street is basically saying to them "Gee, enough of this charade, you guys have got to shrink your balance sheet or otherwise we'll take your market cap down to zero."
well, the backstopping has started, I saw some Paulson header.
The thing with playing these is that there are too many unknown gov. Variables, look at the 2 PM rally in the market on friday...
Yep, just read the NYT article.
It's really a case of the tail wagging the dog here...Says Paulson" we have to backstop them so they can sell a measly $3 billion in short term debt at auction tomorrow."
I bet he wonders if he really ever left GS.
Both of the GS entities have to be unwound now. Assets have to run off, bondholders need to take haircuts, equity holders need to be diluted. We need an orderly shrinking of these GSE's as their business model, like the business models of MBIA or LEH, are irredeemably broken.
I too, will be watching from the sideline...although if this short gamma trade works, Adam, it will all be YOUR fault!! Ya hear!!1
karl k I agree, you have to know when to hold em and when to fold em.
I guess at the end of the day, it's all about the specifics. An ATM (of Friday prices) straddle sale probably would lose today, a nearby strangle probably wins. Volatility has to dip here across the board, though it will still remain on the moon.
Strange when you say a 30% move and the likelihood that it won't exactly stabilize so fast is probably not good for options owners.
Well, it will be very interesting to see these options prices and vols at the open.
On my platform, vols are already changing with the bid for FNM up to 12.64.
Delta neutral at the start now requires 1 contract of the 5 put to 3 contracts of the 10 calls.
Breakevens for the short gamma/buy are at $5.95 and $21.26, with 50% return at the top of the curve, assuming vols stay the same.
For the long gamma/sell, back month vols only have to drop 75% from, say, from the mid 300% to 400% down down to 225-250% or thereabouts. If so, you make money anywhere along the price curve...and at some price points, double your money.
It will be interesting to see how those back month vols perform on the open.
Back month vols have dropped 75 points or so on the open. 4 minutes into the day, they are now in the 200s.
still nutty prices, I mean when the strangles/straddles equal the total dollar risk on the downside, they're pricing in eventual worthless equity.
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