Jump into the Mortgage Companies for Op Ex?

Ok, ok, so I must be looking a little bipolar talking about going long mortgage companies after my rant about how bad housing is and that its going to get worse earlier today. And before I continue let me first say that I am in no way attempting to give financial advice here, just talking about a few thoughts I had about the markets. Buying mortgage companies for the long term is financial suicide and even buying them for a few day trade is EXTREMELY RISKY. These guys are dropping like flies and at any point one could file for Chapter 11 and the stock gaps down 90% like AHM did.


That being said, this is a trade that I made back in March and have been looking forward to for weeks. The timing is crucial and you better have a tight stop if you are going to attempt anything like this. But I wouldn't be surprised to see 100%+ upside moves in stocks like NFI, LEND, LUM, RDN, IMH, etc, etc. Comment on this post and I will mention a whole slew of other candidates.

Heres the idea. It has been impossible to get shorts on these stocks for months, and in some cases like NFI, for years. But alot of people have been making money on the downside, in fact gobs of it, how? They bought puts. Now they are sitting on massive profits over the last month as these stocks have been in free fall. Furthermore, much of the profit has come in the spike in implied volatility that shows up in the premium the options have based on time till expiration. In some cases the puts on these stocks have the highest implied volatilities I have ever heard of, ridiculous numbers like 200%+ on NFI options (see plot above). That compares with 20% ish on the QQQQ (nasdaq 100 etf).


When someone buys or sells an option it has more or less the same effect on stock price as trading the stock it's self. Buy a ton of calls and a stock will go up as the option market makers buys stock to hedge himself and lock in the profits from the sold premium. Sell the call back and the market maker has no reason to hold the stock anymore, hence selling the stock. The same goes for puts and I expect a ton of puts to be sold next week as traders lock in profits before their puts expire with no time premium left. You might be thinking, well how can the market maker short the stock (when someone buys a put) when everyone else is unable to borrow shares. Well there is a neat trick they have called naked short selling. Thats where they sell stock that is not borrowed. It is illegal for most market participants to engage in the practice of naked short selling, but there is an exception for option market makers on the basis that it is only temporary (since the options expire). Neat huh, kinda makes you want to be an option market maker.


So as puts are being sold hand over fist next week on stocks like NFI, LEND (which was down 50% in the after market on news you can read if you care to) and others the option market makers that sold them will cover the stock they are short. You see, option market makers are not in the business of speculating. All they want are those big fat juicy premiums they get by selling options, so they will not want to be short these stocks as people sell back the puts.

I've posted a few charts here of stocks showing how they reacted to options expiration back in March after a similar down fall occurred in these share prices. Some never recovered and went bankrupt, like New Century Financial. But others showed ridiculous intra day moves to the upside. LEND went from 3.77$ to $13.75 in three days, for example. So just take a look at these charts and notice what happened in March. I'm thinking NFI and LEND will be the big movers this week, but we'll just have to see.


As a cautionary note, buying calls on these stocks is expensive and risky especially this close to expiration. You have to watch the implied volatility in real time because the volatility is so volatile. In other words the stock could go up 20% and the calls go down because you bought at the wrong moment. This is a very tricky situation to be trying to trade options on and if you were going to do it, I would think the ideal play would be to short the puts (which is also very risky). Long story short, if these stocks make the types of moves I am expecting this week you will be able to get plenty out of the stock movement. Although, some LEND calls I bought back in March showed me 1,000's% profits in a few days. Yeah.

So I hope you don't mind a little Sunday rock blogging, a phrase I got from a new favorite blog of mine: Calculated Risk. Hoping for a big jump in the mortgage lenders next week after a nasty start so I can get into some positions. Would Running with the Devil be more appropriate? Maybe later this week.


Also, the poll (top right) will be closing at midnight tomorrow (Monday) so if you have not, please take a moment to vote. So far the readers are predicting a bear market and I want to be able to say you called it, if thats what transpires. Good luck, and be safe.