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The Set Up


True to form, Fannie Mae(FNM:NYSE) has been grinding higher of late and this morning got an extra boost from Merrill Lynch(MER:NYSE) who improved their ranking on the stock from neutral to buy. In reading their comments this morning, I got the feeling that the details were less bullish than the headline recommendation and therefore, may be based more on their realization that the short base in the stock has increased substantially (which it has). FNM's latest path is a lesson in the information provided by option pricing.

Over the last several weeks there has been an increase in the implied volatilities of FNM options due to a preponderance of put buying, especially out of the money puts, as hedgers and speculators alike have paid a higher and higher price for protection. The implied volatilities have gone from 25% to 32% in the at the money strike and reached as high as 45% in the out of the money strikes. As puts are bought, the market makers who sell the puts short stock to hedge the delta, and the higher option prices mean they short more than at lower prices (increase in short base).

Increased concern first manifests in option prices. Option prices were bid up fairly dramatically in the spring and then the stock began to rally. When option prices are bid up, it indicates a crowding in the stock, an imbalance in supply and demand. When too many own puts and are ready (and willing) for the stock to go down, it will often do the opposite: being prepared for a decline means traders are unprepared for a rally. That is how markets work, at least in the short run.

Concern soon turned to complacency as the rally forced put holders out of their position and caused more stock buying as market makers bought stock in unwinding their position. The rally was substantial and so was the drop in option prices. The stock topped right around the point where the option prices bottomed.

So it looks like the process is repeating itself. We are already this morning starting to see option sellers. I expect this to continue for some time, but it is never clear when things will turn: the stock may turn down again with just a modicum of a drop in option prices or the stock may continue up even as options get very cheap. It can be dangerous to use option prices as a timing tool (fundamentals will overwhelm technicals if they are unexpected), but the information is still useful. Option prices are like sentiment indicators: they can be useful warnings, but by themselves will not drive the markets. They indicate complacency or concern, but neither may change for a while.

As a volatility trader, I sell these out of the money puts to those paying up in price (short gamma) and buy out of the money calls from over-writers (when available) at cheaper prices (long gamma) to earn the spread in price.
Position in FNM

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