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More on FNM Options


Thank you Frank Raines!


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Editor's Note: Minyanville is a community of people who share an interest in fiscal literacy. As perspective is an important aspect of our daily routine, we share this exchange with hopes that it adds balance to your process.

Earlier on the Buzz, you said that Fannie Mae (FNM) would either gravitate towards $40 (if it is near $40 @ expiration) or accelerate to the downside (if it breaks $40 by a meaningful amount).

I have always been of the belief that when the options trading public is long options (the dealers/market makers are short the options), it causes an expansion in volatility (i.e. as the stock moves, one way or the other, the dealers/market makers must re-hedge, thus adding volatility). If the options trading public is short options (dealers/market makers are long the options), it causes a contraction in volatility because they are providing a bid underneath and an offer on top.

That was an extremely simplistic example and I didn't bother to "show my work" because I'm sure you already know how I got "there."

Under your example, I would imagine that the dealers/market makers (those who are more likely to hedge their options positions) must not be "constantly" re-hedging. How "often" (time/price/implied volatility-wise) do they re-hedge?

I realize that the answer to that varies because you are going to have some who over-hedge and some who under-hedge (probably some who under-hedge to the point that they are double-long or double-short), but surely there is some sort of workable range.


Minyan Ryan

MR -

I agree. It all depends on who is short the gamma and who is long the gamma and how they react. It also depends on what is driving the move in the stock: an earnings shortfall is very different from an accounting scandal.

In general if dealers/brokers are short the gamma they will re-hedge because they are levered and therefore have a strong tendency to want to be "delta-neutral". They therefore re-hedge aggressively causing a pick-up in volatility. When the public is short gamma (short options), they normally are unlevered and are willing to take delivery of stock, so they tend to re-hedge little. Of course these are generalities and there are many flavors in-between.

In the case of FNM it looks like a large holder of stock bought over 15,000 January 40 puts to protect their position back on February 2, 2005 (either that or it was a speculator buying out of the money puts). This has left the dealer community short January 40 puts, which now have a high total interest of 49,000.

Combined with the fact that the reason for the stock drop is an accounting problem (shaking my head), the stock is likely to be volatile as traders re-hedge aggressively and uncertainty has risen dramatically (where is Frank Raines?).

I took the opportunity to sell volatility based on the rapid rise in relative option prices. This is the opposite of my position back up at $75 where I backed up the truck and bought it. Of course my short volatility position has a "delta bias" to it and my position is small (short volatility positions I trade pretty much unlevered to allow me to "weather the storm") relative to my long volatility positions of the past.

So the FNM position is pretty much over for me. Thank you Frank Raines, I hope you get all that is coming to you.

Prof. Succo

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