We may be getting closer to the buyer of last resort hypothesis that I have talked about for some time. Which is where the US Federal Reserve (Fed) steps up to the plate and assumes the liability of US mortgage backed debt.

If this comes to pass, the most likely scenario would be a bailout of Fannie Mae (NYSE: FNM, US$5.00) and Freddie Mac (NYSE: FRE, US$2.81). A bailout that could cost US taxpayers as much as US $1 trillion.

A Fed sponsored bailout would almost certainly leave FNM and FRE common shareholders with nothing (see charts of common stock performance), and quite possibly, could shut the door on preferred shareholders.

Certainly that’s what the options market is thinking. With FNM at US$5.00 per share, the Sept. 5.00 calls were trading at US$1.50 with the Sept 5.00 puts at US$1.50. In other words, the FNM Sept 5.00 straddle that expires in four weeks would cost you US$3.00 per share. Which is to say, the options market has an implied four week trading range on Fannie Mae of $2.00 to the downside.

With FRE at US$2.81, the Sept. 3.00 straddle is trading at US$1.90 per share. In terms of an implied trading range, that is equivalent to US$1.10 on the downside (US$3.00 strike less
US$1.90 cost for straddle) and US$4.90 to the upside (US$3.00 strike plus US$1.90 cost for straddle) over the next four weeks.

If a bailout occurs, the FED will likely take over both FNM and FRE at the same time. It is unlikely that one would get bailed out while the other is left to languish. What has probably delayed action so far, is the fact that other investment banks are teetering on the brink. The problem for the Fed is deciding who they will save and who they won’t.

Lehman Brothers (NYSE: LEH, US$14.41) comes to mind, although news that a Korean bank may be interested in buying the company could remove that company as an obstacle to the buyer-of-last-resort scenario. Although at this point, the Lehman news is as much rumor as it is fact.

If a Lehman takeover firms up, it could speed up the bailout process. But even without that, I suspect a bailout, if it is does occur, will take place prior to the Presidential election in November.

When dealing with abnormally high option premiums, the strategy of choice is usually one in which you hold your nose and buy the puts for as speculative trade. At whatever the cost. Because, a bailout which would leave the stock at zero.

Having said that, there is still a possibility that a bailout will not be necessary. After all, US Treasury Secretary Paulson still believes that the best solution for FNM and FRE is to have them operate as they are currently structured… publicly owned companies.

And so we have a situation fraught with peril and possibilities. At least for speculative traders. One possible speculative strategy assumes a bailout will occur, but not until after the options expire in October. The idea is to buy FRE at US$2.81 and write the October 3 calls at US$1.15 and the October 3 puts at US$1.25.

The total value of the premium received is US$2.40 per share. Here’s where it gets interesting. If FRE survives and a bailout is not necessary – a highly speculative point of view – then the stock will rise and you be required to sell your shares at US$3.00 per share in October.

If FRE is the subject of a bailout but nothing happens until after the October expiration, it is also likely that FRE will continue to trade where it is or slightly higher. Again suggesting that you would be able to sell your shares at US$3.00.

The point is, there is potential with this trade. If either of these scenarios pan out, your net out of pocket cost for your initial block of FRE shares is only US 41 cents per share (initial purchase US$2.81 less US$2.40 per share in premium = US 41 cents). Selling your shares at US$3.00 would result in a 630% profit over eight weeks. A supercharged return for a highly speculative trade.

On the other hand, if the stock is below US$3.00 per share in October – which market participants believe to be the most likely scenario – you would be required to purchase additional shares at US$3.00 per share. Your average cost for FRE shares at that point would be US$1.70 per share (initial out of pocket cost US 40 cents + US$3.00 from a put assignment in October divided by 2 = US$1.70 per share). In a bailout scenario with a zero stock value, you could lose US$1.70 per share on the total number of shares purchased.

So, is this a speculative trade worth considering? The answer, as with all such speculative trades, is to ask yourself, if you would be willing to buy FRE Oct 3 puts betting that a bailout will occur within the next eight weeks. The cost for that bet is US$1.25 per share.

If it happens in the next eight weeks, you would double your money, again, assuming FRE is at zero. But if it doesn’t and the stock rises, you could potentially lose your entire investment. Bottom line, when looking at a speculative trade with supercharged option prices, it really comes down to your view on the underlying stock and how to best take advantage of the scenario.

The advantage, when options premiums are in the stratosphere, is that you have more strategy choices.