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FRE and FNM Volatility Play


When two highly correlated stocks exhibit a significant difference in option pricing, it peaks my interest. The market is normally right in the long term, but very often wrong in the short term. Since option prices reflect sentiment early, often even before the actual stock prices, we study the situation to try to understand the reason for the discrepancy and whether or not it is a short term phenomenon or more fundamental in nature.

These two companies; Freddie Mac (FRE:NYSE) and Fannie Mae (FNM:NYSE) generally operate in the same marketplace, although FRE targets a segment of the market with slightly lower income levels. Market or industry fundamentals are unlikely to affect one company significantly more than the other. In understanding the difference in option prices, we therefore need only look at how one company is run versus the other. Any lasting difference in the volatility (and correlation) of their stocks will most likely be due to how well they execute and what degree of risk the companies assume (leverage). After much analysis, we have decided that FNM, which has much lower option prices, is actually a riskier company. This conclusion was fortified by some notations by FRE management indicating that in order for them to compete, they must raise the risk level of their operations to that of FNM. The public problems at FRE may well be justified, but our conclusion is that any mismanagement and subsequent earnings problems are more symptomatic of the industry and the place these companies occupy within it. Another important variable in analyzing the correlation between the two is the products they provide. If one company came up with a superior product to the other, this would cause a lasting de-linking between the two; correlation would drop. It is hard to imagine one company taking much market share from the other because they make better "loans": money is money.

FRE at the money options in January of 2005 were trading at an implied volatility of 39%, while the options of FNM were trading at 26%. This is quite a difference and implies that the correlation between the two will break down. The historical correlation has dropped significantly (FRE stock price has dropped more than FNM stock price), but this is not necessarily indicative of the future. The strategy entails selling options delta neutral in FRE and buying options delta neutral in FNM to capture the "spread" between the implied volatilities of the two. An important point which I have alluded to is that what we are actually doing here by buying volatility in one stock versus selling it in the other is trading the implied correlation between the two: a higer future correlation between the two will bring the option prices in line. We don't really care if the volatility (and option prices) of FRE goes up (causing a loss), as long as that of FNM go up as well (and hopefully more). If the problems are overblown that have sent the stock prices down of these two companies (FRE more than FNM), FRE stock price will outperform on the upside; if they are not, FNM will under perform on the downside. To hedge against further deterioration in the correlation (my risk), I will delta hedge the position by "leaning" slightly long FRE and short FNM.

I put this spread on at the implied volatilities I have indicated. So far the trade has worked as FNM implied volatilities have risen to 31% and those of FRE have dropped to 37%. I am unlikely to put more on at these levels, but will hold the trade through expiration unless the option prices correct significantly: I am willing to have them come in all the way to parity and still not unwind it.

This trade only makes sense to initiate if one is set up to trade volatility professionally, where cheap leverage and transaction costs are available. Many Minyans have asked me to describe the trades that I do; this is one type. I did not describe the math behind for the purpose of clarity.
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Positions in FRE, FNM.

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