QF206. Week 11A. Long-Short Strategies. Margin. 1 of 29 March 13, Christopher Ting

Transcription

1 Long-Short Strategies Margin 1 of 29 March 13, 2017

2 The First Hedge Fund A. W. Jones Alfred Winslow Jones by 1948 he d left Fortune and working on a freelance article for the magazine entitled Fashions in Forecasting While researching this piece, he interviewed the most successful money managers of the time and began to formulate ideas for a new type of fund. But Jones was not convinced of his ability to predict the direction of the market consistently. 2 of 29 March 13, 2017

3 Out-of-the-Box Thinking His fundamental insight was that a fund manager could use 2 techniques: buying stocks with leverage (margin account) selling short other stocks. Each technique was already well known by the market and was considered highly speculative. But when properly combined together, this could reduce the overall portfolio risk and result in a conservative portfolio, with a low market exposure. 3 of 29 March 13, 2017

4 Trading with Margin Initial margin requirement m 0 : Minimum cash outlay to buy N S 0 : c = m 0 N S 0 Equity for a long position: e = N S (1-m 0 ) N S 0 Paper return of a long position R p e c 1 S S m S Liability Asset Maintenance Margin m m Condition of no margin call e NS m m 4 of 29 March 13, 2017

5 Long Margin Position Initial margin m 0 Proportion of the equity price S 0 per share that must be paid initially S 0 m 0 Maintenance margin m m Minimum proportion of the equity to the market value Asset S at market value, i.e., S 0 becomes S Liability (1- m 0 ) S 0 S 0 (1 m0) S S m m S 1 m 0 Margin S0 1 Call mm 5 of 29 March 13, 2017

6 Margin Call for a Long Position e NS Eg. S 0 = $9 m 0 = 0.8, m m = 0.7 m m S 9 6 S 1 m 0 1 mm S 0 S Time Margin call 6 of 29 March 13, 2017

7 Insight! Leverage Brokerage fee is a proportion x of transacted value. Daily interest rate is i and the position is closed 1 day after the purchase. Assume all costs are paid at the time of squaring off. Paper rate of return R p Costs xns xns i(1 m ) NS R r Equity Costs Cash flow at time 0 S S0 2 x i(1 m0) (1 x) m S m (1 x) R x i(1 m ) 7 of 29 What financial insight can you March obtain 13, 2017 from this cash-flow return? p m 0 0 m 0 N S 0

8 Put into Practice The realization that one could use speculative techniques to achieve conservative ends was the most important step in forming the hedge fund. In 1949, Jones formed a general partnership with 4 friends, became the Managing Partner, and started a long/short equity fund. To attract investors, Jones invested his own savings in the hedge fund and chose to be paid with 20% of the fund performances, instead of fixed fees. 8 of 29 March 13, 2017

9 History of Short Selling: VOC First case of short selling: 1609, Dutch merchant, organized short sales on stocks of the Dutch East Indies Company VOC listed on the Amsterdam Stock Exchange. In 1610, VOC directors convinced the Dutch States-General to declare short selling illegal because bearish speculators were damaging innocent shareholders The illegal activities continued anyway, instead of forbidding them, in 1689 Dutch government decided to levy a tax on profits from short sales. 9 of 29 March 13, 2017

10 History of Short Selling: South Sea In 1720, the South-Sea speculative bubble burst in Great Britain: In a frantic rush to acquire rights to trade with Latin America, the shares of the South Seas Company shot up from 325 to Later on, the shares of the company tumbled to 86 and short sellers were blamed. In 1734, short sales were banned: however the law remained unapplied and was abrogated in of 29 March 13, 2017

11 History of Short Selling: Illegal In France 1724, a royal decree prohibited short selling Even Napoleon declared this practice illegal, because he believed that short sales drove treasury prices down, interfering with the financing of his expansionary plans Together with his Finance Minister Mollien, he maintained that short sellers were traitors because they wished treasuries to collapse. Today, hedge funds specializing exclusively in short selling are rather rare and many of them switched to a long/short equity strategy with a net short position, or short bias. 11 of 29 March 13, 2017

12 Lending and Borrowing Shares The availability of borrowable securities depends on their owners and not on the hedge funds. The incentive to lend is given by the fact that the shareholder gets a compensation, which for shares is typically equal to an annual rate ranging between 1% and 5%. Share borrowers also agree to refund any dividends paid out by the stock during the lending period to the original owner. So the shareholder enhances the return on his shares, because in addition to the dividend yield, he gets also a lending fee, that is, a compensation for lending the shares. This is an attractive incentive for institutional investors, who have large equity portfolios. In addition, share lenders have the right to call in the shares at any time, for example, when general shareholders meetings are due that the shareholder wishes to attend. 12 of 29 March 13, 2017

13 Short Selling Risks While short selling may theoretically be considered symmetrical to the purchase of a security, in reality: The downside of a short sale position is potentially unlimited Short squeeze: when a broker demands the immediate delivery of lent securities. Dividend payout: the dividend amount is charged to the short seller and is paid out to the broker who lent the securities Up-tick rule: short sales is allowed only if the latest price change of the security being shorted was an upward movement. Forbidden to short a stock while its price is falling. Liquidity shortage risk: often it is not possible to short sell small and medium cap stock, because the market for borrowing the securities is tight. 13 of 29 March 13, 2017

14 Short Interest Short interest is defined as the number of shorted shares that have not been delivered yet. High short interest levels say that many sellers have sold short in anticipation of a bearish trend. Many traders however believe that a high short interest level is an important indicator of an impending rise in the share price, because the future stock demand from short sellers who have to close out their position will push the share price up. Data covering the short interest of individual stock are of public domain and are published on a monthly basis with a few days delay. 14 of 29 March 13, 2017

15 Short Interest Ratio Short interest ratio is defined as the ratio between short interest and the average daily volume over a given period (generally 30 days) It represents the number of days it would take for short sellers on average to repurchase all the borrowed shares, assuming that all daily transactions are used to close out short sales. A high short interest ratio may indicate that it will be difficult for short sellers to cover their positions. If unexpected good news were announced on a share with a high short interest ratio, the share prices could rise and force short sellers to buy the shares before their price rises even further. 15 of 29 March 13, 2017

16 Short Margin Position Initial margin m 0 Proportion of the equity value that must be paid initially S 0 m 0 Maintenance margin m m Minimum proportion of the equity to the market value Asset S 0 m 0 + S 0 Liability S at market value, i.e., S 0 becomes S S 0 m 0 0 S S S m m S 1 m 0 S Margin 0 1 m Call m 16 of 29 March 13, 2017

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18 Pair Trading A Brief Introduction 18 of 29 March 13, 2017

19 Pairs Trading Pairs trading or statistical arbitrage was first developed and put into practice by Nunzio Tartaglia, while working for Morgan Stanley in the 1980s. Tartaglia formed a group of mathematicians, physicists, and computer scientists to develop automated trading systems to detect and make use of mispricings in financial markets. 19 of 29 March 13, 2017

20 David Shaw One of the computer scientists on Tartaglia s team was the famous David Shaw. Pairs trading was one of the most profitable strategies that was developed by this team of 29 March 13, 2017

21 Pairs Trading Basics The general rule of thumb in trading is to sell overvalued securities and buy undervalued ones. It is only possible to determine that a security is overvalued or undervalued if the true value of the security is known. The true value can be very difficult to determine. Pairs trading is about relative pricing, so that the true value of the security is not important. Relative pricing is based on the idea that securities with similar characteristics should be priced more or less the same. When prices of 2 similar securities are different, one security is overpriced with respect to its true value, or the other one is underpriced, or both. 21 of 29 March 13, 2017

22 Example ACC versus Ambuja Exit Date Profit (%) Duration Long Short 27-May ACC Ambuja 16-Aug Ambuja ACC 04-Oct ACC Ambuja 25-Nov ACC Ambuja 27-Dec Ambuja ACC 28-Jan Ambuja ACC 18-Feb Ambuja ACC 12-May ACC Ambuja 25-Jul Ambuja ACC 13-Oct Ambuja ACC 02-Dec Ambuja ACC 24-Feb Ambuja ACC 23-Apr ACC Ambuja 17-May Ambuja ACC 02-Jul ACC Ambuja 05-Sep ACC Ambuja 19-Nov ACC Ambuja 15-Jan Ambuja ACC 08-Feb ACC Ambuja 25-Mar ACC Ambuja 14-Jun Ambuja ACC 25-Jul ACC Ambuja 06-Aug Ambuja ACC 22 of 29 March 13, 2017

23 How Pair Trading Works (1) of 29 March 13, 2017

24 How Pair Trading Works (2) liq, go short go short liq, go long liq, go short liq, go long liq, go long liq liq, go short liq 65 go long 24 of 29 March 13, 2017

25 How Pair Trading Works (3) +500 liq, go short go short go long -200 liq, go long liq, go short liq, go long Plausible rule: Mean spread 3.0 with stdev 1.6 Go into action when spread +1.5 or -1.1 stdevs. Funds use math and statistics to figure out the best strategy. 25 of 29 March 13, liq, go short liq, go long +300 liq +200 liq +500

26 It s All About Spread! Buy low and sell high 26 of 29 March 13, 2017

27 Pair Trading and Spread Trade one asset (or basket) against another asset (or basket) Long one and short the other Intuition: For two closely related assets, they tend to move together (common trend). We want to buy the cheap one and sell the expensive one. Exploit short term deviation from long term equilibrium. Try to make money from spread. Z = X βy What is β? Hedge ratio Co-integration coefficient 27 of 29 March 13, 2017

28 Dollar Neutral Hedge Suppose ES (S&P500 E-mini future) is at 1220 and each point being $50, its dollar value is about $61,000. Suppose NQ (Nasdaq 100 E-mini future) is at 1634 and each point worth $20, its dollar value is $32,680. β = = Z = ES 1.87 NQ Buy Z = Buy 10 ES contracts and Sell 19 NQ contracts. Sell Z = Sell 10 ES contracts and Buy 19 NQ contracts. 28 of 29 March 13, 2017

29 Risks of Pair Trading Strategy β changes with time, covariance, market conditions, etc Periodic recalibration is needed. Long term equilibrium may be dynamic. Systematic market risk is residual Firm specific risk Liquidity 29 of 29 March 13, 2017