Short Selling Levels Are Down: Is This A Surprise?

Posted by Bull Bear Trader | 10/25/2008 06:47:00 AM | , | 0 comments »

It appears that short selling levels have receded at both the NYSE and Nasdaq in the first two weeks of October, falling 8.3 percent on the NYSE and 10.5 percent on the Nasdaq (see WSJ article). As quoted in the article:

"This decline in short interest, particularly the decline in brokerage stocks, is a continuation of a 12-week trend. Shorts have been large net buyers and therefore stabilizing these stocks, calling into question the rationale behind the SEC's ban on shorting."
You ban short selling and it results in less shorting and more short covering. Is this a surprise? As for refuting the rationale behind the SEC decision, I am not sure the trend is really calling the ban into question. If anything, the trend supports the decision (even if for other reasons it was short-sighted - no pun intended, see previous posts here and here). Of course, one could argue that the ban was lifted October 8th, therefore the second week of short interest declines shows that the ban was not necessary to reverse the trend. Yet given the SEC's recent proclivity to change the rules at the drop of a hat, not to mention the significant market decline (and recovery and decline) over the last few weeks, it appear likely that only a few brave traders would take such a position, even if it seems to make sense. I suspect that someday rationality will re-enter the picture, but it probably will not happen until the short selling cuffs are taken off the invisible hand of the free-markets and thrown away for good.

According to a Financial Times article, a European commission examining the credit derivatives industry is asking CDS traders to reduce risk. Ah, if it was only that easy. Kind of like asking someone running a garage sale in the 1980s to sell their old eight-track player for what they paid for it. For one, you are not going to get your original value back, and two, very few people are interested in buying something that may be worthless tomorrow. It is also kind of ironic how we need to reduce risk on the very item we were using to reduce risk in the first place. At some point you cannot just keep passing risk along. Someone has to bear it - which is unfortunately where the government steps in when such exposure is contagious. Fortunately, besides asking for the obvious (and possibly impossible), the commission is forcing its hand a little, stressing how they want a clearinghouse for credit derivatives - otherwise legislation could be introduced. If that is not enough to put the fear in the industry, I am not sure what else is.

What is the hot new hedge fund strategy? Convertible Arbitrage? Distressed Debt? Emerging Markets? Event Driven? Macro? Long / Short, Risk Arbitrage? Quant? No, if a new hedge fund by a former Columbia professor is any clue, it is value (see Bloomberg article). The new company, called the Van Biema Value Partners, plans to invest in no more than 20 small Asian managers that follow value investing principles. When people start losing significant amounts of money, it is interesting how Buffett and Templeton start to appearing wise again.

Strangles Generating More Interest

Posted by Bull Bear Trader | 10/23/2008 11:20:00 AM | , , , , | 0 comments »

Recently, high volatility is causing some option strategies, such as selling strangles, to look appealing again (see WSJ article). A strangle is an option strategy where you buy out-of-the-money puts and calls, as opposed to a straddle where both options are at-the-money. For those buying the position, you are hoping for volatility - with movement in either direction. Right now, as a result of higher volatility, the strategy is more expensive than it has been in the past, offering opportunity for those who sell the position. Typically, selling the strategy is safer when the straddle options are deeper out-of-the-money, but of course, deep out-of-the-money options do not usually generate as much premium - until now. The higher volatility has increased premiums to the point that deep out-of-the-money options, even for those tied to historically lower volatility stocks, are looking attractive. Each position needs to be considered carefully for risk and reward, but those with the stomach to sell option are seeing new opportunities and possibilities.

As hedge fund investors find it difficult to unload their shares (often due to missing redemption deadlines, or not wanting to wait through their holding period), some are utilizing the secondary market to sell their shares (see WSJ article). Hedgebay Trading Corp., which began business in 1999, operates a secondary market to match buyers and sellers of hedge fund stakes. Initially, when hedge funds were doing well, Hedgebay would have buyers paying a premium in order to take a stake in an attractive fund that may have been closed to new investors. As the market has turned, investors are now offering their shares at a discount, with the average discount recently doubling to 3.5%. Clients include individual investors, funds of funds, pension companies, and endowments. Funds of funds in particular have been aggressively utilizing the site and have actually redeemed more money than they need out of fear that when they do need the money, the individual hedge funds will put up redemption gates. JPMorgan has estimated that there will be up to $100 billion in redemption requests from funds of funds in Q4. The secondary market has even generated new opportunities for Permal Group, which is launching a $500 million fund that buys distressed priced hedge fund stakes, with shares coming from Hedgebay and existing relationships. Just another example of how capitalism does amazing things when it is allowed to operate. Now if only some private entity can do this efficiently with credit default swaps and credit derivatives, investors might actually be able to once again sell attractive hedge fund stakes for a premium.

Hedge Funds That Hedge Are Doing The Best

Posted by Bull Bear Trader | 10/22/2008 07:37:00 AM | | 0 comments »

According to a Dow Jones Financial News article (subscription required) and data from Hedge Fund Research, equity market neutral hedge funds made 0.3 percent so far this month (to October 20th). Equity market neutral funds look to profit from the markets regardless of their direction, putting equal positions on share prices rising and falling, leaving the portfolio as a whole uncommitted to the general direction of the market. Market neutral hedge funds are also up 0.4 percent total for the year. Given that market neutral funds are one of the few funds that actually seem to employ hedging, it is often considered by some to be a pure play, or true hedge fund. Imagine that. A hedge fund that hedges, doing the best when the market is volatile. Then again, being flat is a little boring (albeit nice when the market is tanking).

As if the credit markets did not have enough problems with actual credit default swaps (CDS) and collateralized debt obligations (CDO), now it has to worry about their synthetic relatives (see WSJ article). While synthetic CDOs have been talked about for a while, additional pain from synthetic CDO losses may be on its way, possibly setting back any recovery in the credit markets.

Synthetic CDOs essentially allow banks, hedge funds, and insurance firms to invest in a diversified portfolio of companies without directly purchasing the bonds of the companies. Unlike normal CDOs, synthetic CDOs do not contain actual bonds or debt. In order to provide the normal income stream generated by CDOs, synthetic CDOs provide income by selling insurance against debt default. Each synthetic CDO typically has numerous companies with good to high investment-grade credit ratings (often AAA or AA). Like a normal CDO, different tranches, or levels of risk and return are sold. Insurance companies typically purchase the higher rated senior and mezzanine tranches, while hedge funds, looking for higher return, yet willing to bear or hedge the additional risk, might invest in the lower-rated or unrated equity tranches. As the credit crunch progressed, many CDOs had exposure to financial companies, such as Lehman Brothers. Such exposure has caused previous AAA-rated products to now trade for 50 cents on the dollar, falling from 60 cents just a few weeks ago. The resulting hedge fund liquidation is pushing up the cost of default insurance, which in turn is raising the cost of borrowing, and putting more pressure on the credit markets.

Specialized funds, such as Constant Proportion Debt Obligations (CPDO) are also causing problems. If you felt that CDOs were not complex or risky enough, no problem. CPDOs juice returns by adding leverage, as much as 15 to 1. Of course, such leverage is risky, so many CPDOs have safety triggers that force them to exit their investment if their losses reach a certain level. Unfortunately, many are starting to reach their trigger levels. Some companies that sell protection on credit derivatives, called Credit Derivative Product Companies (CDPC) or Derivative Product Companies (DPC), have made matters worse by leveraging as high as 80 to 1. The CDPCs are similar to the monoline financial guarantee companies (remember Ambac, MBIA, etc.), except they do not have the burden of regulation (ah, remember the days). In order to stabilize company returns and ironically help secure a AAA rating, such companies would not post collateral, since posting collateral on trades could force collateral calls on losing trades and force portfolio selling. Of course, now, many firms are learning what forced selling is all about, or even worse, insolvency.

Hindsight is usually 20-20 (except when you still don't understand the product or exposure), but you still have to wonder how things were allowed to get so out of control. As an analogy, does it really make sense for me to be able to take out insurance on my neighbor's house, as well as mine? Should every neighbor on my street be allowed to insure against my house burning down? Or even better, on a house that does not even exist? Apparently so. Greed and common sense are not always close friends.

If You Ban Shorting, You Ban Information

Posted by Bull Bear Trader | 10/20/2008 02:04:00 PM | , | 0 comments »

There is an interesting article today in the WSJ regarding the recent short selling ban, along with its unintended consequences. While the effects on hedging, volatility, and widening bid-ask spreads have been discussed at length, what often gets lost in the discussion is the effect on market efficiency (see previous post). As quoted in the recent article:

"Why would regulators ban short selling in nearly 1,000 companies, effectively banning accurate information from the markets? By targeting short sellers as a way to prop up share prices, regulators clearly panicked. This in turn panicked financial professionals and individual investors who saw regulators losing faith in the system they oversee."
In a sense, by trying to stabilize stocks, current actions have made them more volatile. Even worse than affecting individual stocks, such bans have destabilized the confidence and structure of the market itself, and made information flow less transparent. Individual stocks can recover, or can be sacrificed, but confidence must be built. Market structure must be consistent and trusted. Hopefully we have learned our lesson over the last few weeks as we continue to watch greater than 5% daily swings, not to mention material market moves (often down) every time someone from Washington shows up at a press conference.

There is an interesting article over at the All About Alpha site regarding the impact of the short selling bans on 130/30 funds. While the article discusses the obvious challenge of maintaining a 30 percent short position when many stocks cannot be shorted, it brings up an interesting point about data and quantitative modeling. As quants go forward with model development, they will need to be careful when back testing their models given the periods of time in the market when short selling was either restricted or tightened for various equities. As one expert was quoted as saying:

"Managers with quant models for generating trades will probably have their heads in their hands. Not only will the quant models have to be redeveloped, but the managers will lose months if not years worth of model evolution, back-testing and intellectual investment. I can predict a few horror scenarios where code and expertise in these models may have been lost.”
There is no doubt that many non-quants or retail investors will say "big deal, isn't it just a bunch of traders taking the hit? Why should I care?" Yet, they should. Besides attempting to make a profit and generate abnormal return, quant funds, like many other strategy based funds, seek to profit from inefficiencies in the market, which ironically helps to keep the market more efficient. When this ability is hampered, as it is when short sale rules are not only changed, but selectively changed, you just add more inefficiency and market volatility (have you seen the VIX lately?).

Sure, naked short selling is wrong, and bans need to be enforced, but interfering with the normal market checks and balances could take months to sort out, even after short selling rules are returned to normal (or at least consistent for more than two weeks at a time). Until then, risk management, arbitrage, and finding someone to take the other side of the trade will be more difficult. All the while, day traders will continue to enjoy the volatility, while retail investors will continue to get nauseous, wondering if things will ever calm down.