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Sallie Mae Crush


There is a phenomenon in option pricing that can be exemplified by Sallie Mae options: as stock prices rise, relative option prices as defined by implied volatilities go down. I suppose this makes some sense on a subjective basis: as the stock rises, investors assume that all is well. If they are looking to hedge by buying puts, they don't pay up while market makers become more willing to sell them. If they are looking to hedge by selling calls, they tend to stick to a price, which forces the implied volatility of the calls down as the stock rises. The fall in implied volatilities, however, is not justified by the math.

Over the last two days, SLM stock has risen 3.9% and 3.4% respectively. This implies an actual volatility of around 54%. Having a long volatility (gamma and vega) marked at a 26.5% volatility, it is expected that my position would make quite a bit of money (the stock has moved basically twice what the option prices imply). On the contrary, the position has lost on a mark as the options have actually declined to a 24.8% volatility. Profits in gamma re-hedging have been dwarfed by the loss in vega.

The supply and demand dynamics of the options, driven by future expectations, are dichotomous to the actual pattern of volatility in the stock. Expectations may be right, but one thing is for certain: if the actual volatility of the stock continues at anything greater than 50% of its current pace, eventually gamma re-hedging will overcome the vega factor and money will be made. There is a valuable lesson here: try to always build long volatility positions when the market is complacent, usually when stocks are rising, and never buy it when everyone wants to, when stocks are collapsing (that is when you want to sell it). I continue to build my position in these options.
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