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Format Modification

We are modifying our format in order to allow more time and space for option strategy recommendations. There are many Websites devoted to the analysis of current financial market conditions, but there are fewer that convert the analysis into specific actionable trading suggestions using option strategies. We think this is where we can add the most value and where we should devote most of our time and effort.

While we will continue following and periodically commenting on Market Implied Volatility, The Dollar Index, Market Breadth, and Interest Rates they will no longer be included as regular weekly sections in the IVolatility Trading Digest™

Home Mortgage Market

Most of the news this week was about the problems in the US home mortgage market and the lack of secondary market liquidity for these loans. There is a lot of really good analytical material on the Web at various sites so rather than just repeating the information we will limit our comments to just a few noteworthy observations.

In 2006 14% of all mortgages issued were “liar loans”, as they are known in the mortgage industry. These are loans that required little to no documentation or income verification.

In its latest financial report Downey Financial Corp. (DSL) 52.91 reported that 108.2% of its “Earnings before Taxes” for 6 the month period to June 30, 2007 was "Interest from Negative Amortization". This is income recognition of capitalized interest from negative mortgage loan amortization. Interestingly this seems to be in accordance with Generally Accepted Accounting Principals. They then went on to declare a .12 per share dividend based upon this "income".

Here is the volatility chart:

The market implied volatility now in the low 60’s has declined from the mid 70 range before the second quarter report, making it a tempting target.

Here is the 30 days options volume chart:

Current put/call volume appears fairly close, but there are more puts outstanding than calls. Nothing very unusual here.

And now for the 30 day Put/Call ratio chart:

Again, nothing unusual here, the ratio rose to over 7 before the earnings report and has now declined back to about 1.6.

In light of the fundamental conditions and current uncertainty in the mortgage market it appears that the options are about right with the market-implied volatilites the 60s. We would not want to be using short DSL options strategies, despite the tempting positive volatility spread as the implied volatilites may rise again. Four analysts cover this stock and as yet, none have issued sell ratings.

Consider this direction-biased put spread suggestion.

Trade Plan

DR: An illiquid secondary mortgage market and declining real estate values are likely to worsen in the near future. This does not as yet appear to be fully reflected in the stock price. If regulators should disallow the capitalization of negative mortgage amortization it would require a restatement of prior years earning. The result would be a material decline book value, an important metric for this industry. We expect a further decline in price with rising implied volatility.

SU: A closing price about 55 would cause us to change our near term opinion and would require unwinding the spread by selling the long put.

Buy DSL Nov 55 put DSLWK 7.45 IV 60.25 Delta -.4763 Vega .1092
Sell DSL Nov 45 put DSLWI 3.45 IV 68.32 Delta .2535 (sold put = positive delta) Vega .0880
Debit 4.00 Position net delta -.2231

An alternative strategy would be a put ratio back spread that would benefit from the decline in price and the increase in volatility.

More Mortgage Money Makers

We first suggested a put spread on Washington Mutual Inc. (WM) 35.95 in IVolatility Trading Digest™ Volume 7, Issue 25, dated July 30, 2007. As the number three mortgage lender it also has negative amortization "option ARM" exposure. Analysts’ ratings are 17 holds and one sell. Historical Volatility 38.15

Buy WM Oct 40 put WMVH 4.80 IV 37.61 Delta -.7108
Sell WM Oct 35 put WMVG 2.40 IV 48.21 Delta .3937 (sold put = positive delta)
Debit 2.40 Position net delta -.3171

Countrywide Financial Corp. (CFC) 27.86 is the Mortgage Bankers Association’s top ranked mortgage provider by number of loans and dollar volume. Analysts’ ratings are 6 buys and 4 sells. Historical Volatility 54.15.

Buy CFC Oct 27 ½ put CFCVY 4.15 IV 91.15 Delta -.4056
Sell CFC Oct 22 ½ put CFCVX 2.55 IV 110.17 Delta .2449 (sold put = positive delta)
Debit 1.60 Position net delta -.1607

Bank of America Corporation (BAC) 48.59 is the fourth-largest mortgage lender. Analyst’s ratings include 12 buys and zero sells. Historical Volatility 19.69.

Buy BAC Nov 50 put BACWJ 3.20 IV 23.57 Delta –. 5922
Sell BAC Nov 45 put BACWI 1.40 IV 29.49 Delta .2850 (sold put = positive delta)
Debit 1.80 Position net delta -.3072

IndyMac Bancorp Inc. (IMB) 20.29 is another with mortgage exposure in this category. Analyst’s ratings on this stock are 2 buys and 3 sells. With an Implied Volatility Index of 123.46 and a Historical Volatility of 62.18 consider this suggestion and look at these implied volatility numbers.

Buy IMB Oct 20 put 4.55 IV 137.62 Delta –.3670
Sell IMB Oct 15 put 2.65 IV 162.98 Delta .2140 (sold put = positive delta)
Debit 1.90 Position net delta -.1530

Not too late

Keep in mind what Jessee Livermore said in Reminiscences of a Stock Operator

"Remember that stocks are never too high for you to begin buying or too low to begin selling." p.89.

Reader Response

As usual we encourage you to let us know what you think about how we are doing and what you would like to see in futures issues. Let us know what you think about the change in the format. If you have questions or comments just let us know. If you have some trading ideas that you would like to share with us just use the blog response at the bottom of the IVolatility Trading Digest™ page page on the IVolatility.com Website.