June 1, 2010

Understanding the Space Between Things

REMINDERS: We’ll be bivouacked for NIRI National in booth 321 on the exhibit floor at the Manchester Grand Hyatt in San Diego next week. Stop by! Also, clients, come see us for Happy Hour on Sunday at Busters Beach House. We’ll kick things off.

Speaking of conversations best had around adult beverages, no doubt many of you have laid awake nights wondering, “How does relative value arbitrage work, and should I care?”

First, arbitrage isn’t bad. It’s a path to both profit and protection. Universa, the hedge fund advised by The Black Swan author Nassim Taleb, follows relative-value arbitrage techniques to help clients offset risks (Incidentally, Nassim Taleb remarked about the May Flash Crash that when a bridge collapses, you don’t study the last truck that crossed it; you look for structural flaws.). So the first thing to know is that gaps, or spaces, between things offer chances to profit from spreads and opportunities to guard against an equal but opposite risk. And this stuff will at some inevitable point affect the price of your stock, so it’s best to know about it.

Any trading strategy that focuses on the spaces between things rather than the things themselves is a form of “relative value” arbitrage. Global Macro strategies dominated hedge-fund investment in the 1990s, accounting for roughly 80% of assets under management. It’s not new. And it’s a form of relative value arbitrage. Global Macro techniques are widely used today, except at high speed now. For instance, have a look at indices from structured-products broker Newedge for volatility and macro trading, and you’ll see that they’re predicated on fairly small returns – and losses. Lots of little returns at nominal risk make sense when uncertainty abounds. So it becomes common in stocks too.

Let’s use you as an example. Say your stock trades for $20 right now. A trader with a relative value arbitrage strategy might buy an option, either on your stock or for an index, and then sell your stock for a “long” volatility position. Buying your stock (the underlying asset) and selling the option instead is a “short” volatility position, because the trader is short the potential, or implied, volatility. The trader profits in a long volatility trade if your actual volatility is greater than the implied volatility of the option.

Now that sounds complicated, and it can be. But realize that it’s about the volatility, not your price or the price of the option. Think about it this way. If your volatility is 25% over the life of this trading plan, while the volatility of the option is 20%, that’s a profit, regardless of what caused the spread.

Now suppose the trader is a “liquidity provider” too, offering shares for sale. Now the trader might be able to “move” the price of your stock with high-speed trades, while also holding a volatility play. This is fairly common. If your stock moves from $20 to $18 and back in a day, that could be enough for the trader to profit. What’s more, say you trade five million shares a day and the trader sat between 300,000 shares of that volume with a machine. The trader might’ve pocketed $1,500 on this activity too, as gravy. Duplicate that in a portfolio trade of 30 liquid stocks and combine it with relative-value arbitrage plays, and pretty soon you’re talking real money that’s almost as easy as a government bailout.

So what do you do about this? No, the point isn’t what you do, but whether you understand what’s going on. If your stock’s price moves a great deal intraday but not a lot by the close, there’s a reasonable chance that traders are engaged in relative value arbitrage. And simply having that answer when the CFO stops you in the hall may be the most important thing for now.

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