Considering Our Options – $NLY Call

by Enis November 14, 2014 12:38 pm • Commentary

I bought a call position in NLY on Oct. 1st with a twofold thesis:

1)  NLY was trading near its all-time low Price / Book ratio, indicating a good fundamental value, particularly since long-term rates (where NLY has duration risk) have remained low.

2)  NLY’s implied volatility was priced relatively cheaply vs. the volatility of long-term rates in the U.S.  That allowed me to buy April 11 calls in NLY for only $0.42 in upfront premium, a good risk/reward trade structure more appealing to me than simply buying the stock.

Since then, NLY has moved about 4% higher, though the stock has been flat over the last month.  The April 11 call option is now worth about $0.55-$0.60, which is higher than where I bought it, but hardly a major winner.  At this juncture, I wanted to revisit the trade to make sure the factors central to the thesis are still intact and there is no adjustment to be made to the trade.

First, long-term rates remain in a downtrend, even with the recent bounce.  In fact, the 10 year swap rate has remained below the declining 50 day moving average in November even with the equity market making one new record high after another:

10 year U.S. swap rate, 50 day ma in pink, 200 day ma in yellow, courtesy of Bloomberg
10 year U.S. swap rate, 50 day ma in pink, 200 day ma in yellow, courtesy of Bloomberg


That will hurt NLY’s reinvestment rate on its portfolio going forward.  However, its depressed valuation indicates to us that the near-term risk (to its existing agency bond positions) of a rise in rates is a bigger issue for investors.  With that in mind, the fundamental value in NLY remains quite cheap since long-term rates in the U.S. are actually lower than they were at trade initiation on Oct. 1st.

Second, implied volatility in NLY is now lower than it was 6 weeks ago:

NLY 30 day implied volatility, courtesy of Bloomberg
NLY 30 day implied volatility, courtesy of Bloomberg

The long call position has not appreciated as much as it would have if implied volatility had remained at the level when I initiated the trade.  It does mean now, though, that the option is priced quite cheaply in volatility terms, and selling another call against it is not a good risk/reward proposition either.

I am going to hold on to the call position given that the thesis remains in tact and the trade is currently a slight winner.  In the meantime, we’ll keep an eye on the moving parts for this position.