Shorting AGNC

AGNC is a mortgage real estate investment trust (mREIT). The business is to borrow short term and invest in long term securities thus earning difference in yields. The profits depend on the steepness of the yield curve. Currently the yield curve (from http://seekingalpha.com/article/447131-annaly-still-a-buy-despite-another-dividend-cut) is steep i.e. you can borrow at around 0.50% for 2 years and lend it between 1.5% to 2.0% for 5 to 7 years.



By law mREITs are required to pay more than 90% of their income. So to continue operating these companies need to raise money frequently. AGNC has been issuing equity instead of borrowing.

Recently AGNC cut its dividend from $1.4 / share to $1.25 / share dropping its yield from ~20% to ~16%. I am expecting the yield to go up to 20% and thus price to drop to around 26/27. Based on this belief I recently bought puts on AGNC. I bought June 2012 put at a strike price of 29 for ~$1. Thus my break-even point is at 28. I have up to June 12, 2012 for the price to fall to that level.

The stock has held up fairly well since I bought the Put. I believe the stock has been helped by rising stock market. So, I think I will wait for some more time before closing the position.

Trading Options on NIFTY

I was betting on increased volatility as ATR and Nifty VIX were at low levels. Additionally, as there was no time left in March contract, I did not want to make the bet that volatility would increase in the next 5 days. In hindsight, it would have worked too.

On Friday, when Nifty was trading at 5250, I bought a strangle at 5000 & 5500 in the April contract for Rs. 4015. 

However, immediately after making the trade, I realized the biggest issue. I underestimated the amount I will be charged to make the transaction (Rs. 106 on 1 leg for 1 contract through ICICI Direct). I will be paying approx 424 or 10% of my bet in transaction costs.

As trading ended on Monday, I had a profit of approx Rs. 100 but after factoring in transaction charges I am making a loss of Rs. 331.50.

I am still expecting the market volatility to increase. Nifty VIX is close to its historical lows and ATR is also at low levels. But another problem is the time decay of options. At some point I will have to make a decision to stick with my view or cut my losses.

These are conflicting objectives, if market volatility does not increase then I lose the time value of my options and they expire worthless. So, I should be selling them as soon as possible. However, if I sell them too soon (at a loss) then I lose if the market volatility increases (as is my view).

After reading so much theory on options in my risk management class, I must say the practical aspects of trading are totally different. Theory says if you expect volatility to increase buy straddles (lower risk but more expensive) or strangles (higher risk but cheaper). Practically, there are so many things to think about, transaction charges, time value etc.

I think Rs. 4,015 is a small price to pay for this education :)