If you guys notice I have many trade ideas on this website, but in fact none of them represent my actual portfolio of strategies. I seriously don’t disclose how I make money, similar to all those successful ones. But in this very example, a failed one, I will boldly write down (you can laugh at me) about how I lost this trade, a lesson learnt though.

Something your Brokers, Courses, Seminars, broker fairs, internet websites (some do mention, forums etc) won’t share with you. In fact, I did this to other stocks and had this loss covered up. Think about what I can do with the rest of 8000 stocks in US, Europe, HK markets.

Box Spread Arbitrage

I executed a trade called “Box Spread” Option strategy (those who don’t trade derivatives bear with me.). If you google it, only a few results will show that up. Its basically a self exercising risk-less strategy where at the end of Exiration, you will be net 0, and you should be credited with some money ? Another term for it ? “Box Spread Arbitrage Option Strategy”.

I am sure this is not know to most “retail traders”, and even so it is almost impossible to trade, might require some Maths, some “lightning fast” computers, some programming etc.

The Stock

This gets lengthy.

Like many newbies, even after trading for 2 years, getting pass the emotional and money/risk management, I was almost careless, though I believe in No pain No gain.

I executed a box spread arb on China-Biotics CHBT (Public, NASDAQ:CHBT). Before going into details on my trade, I’ll take this chance on my blog to write out what’s a box spread arb.

Description

China-Biotics, Inc. is engaged in the research, development, production, marketing, and distribution of probiotics products, which are products that contain live microbial food supplements. The Company manufactures and sells several health supplements under the Shining brand in China. All of these products have been approved by the Ministry of Health in China. Its four major retail products comprise: Shining Essence, Shining Signal, Shining Golden Shield and Shining Energy. In February 2010, China-Biotics, Inc. commenced production at its facility in Qingpu and began producing bulk additives products, which are sold to institutional customers, such as dairy manufacturers, animal feed manufacturers, pharmaceutical companies, and food companies. It sells its retail products mainly in greater Shanghai through distributors. As at March 31, 2010, it has opened 111 outlets in Shanghai and 12 other cities in China.

What is a Box Spread Arbitrage

A (Long/Short) box spread involves the simultaneous buying and selling of a Call and Put (debit/Credit) Spread with similar strike price, with the intent of cancelling out each other with the credit spread, risk involve.

Lazy with drawing a diagram, the idea, in my case of Short Box Spread?CHBT, is to simultaneous sell a Credit Call Spread of 3/11, and Sell a Credit Put spread of 3/11.

Ignoring the stock price and fundamentals, an arbitrage opportunity exist in CHBT, known as the Put-Call Parity, where there are price discrepancies, market makers not bidding/asking well, possible synthetic Split Strike.

On 25 May

The Trade (Stock@$7.90++, less brokerage for illustrations) :

1. Sell Call at $3 – Credited with $7.9x – $3 = $4.93
2. Buy Call at $11 – Debited with $0.38 (Out-of-the-money)

• Bear Call Spread Credit : $4.93-$0.38 = $4.55

1. Sell Put at $11 – Credited with $7.9x – $3 = $4.10
2. Buy Put at $3 – Debited with $0.30 (Out-of-the-money)

• Bull Put Spread Credit = $4.10 – $0.30 =?$3.80

Now take the 2 credited amount together and you’ll get: $3.80 + $4.55 = $8.35

Wa la! $8.35 was my magical number. Why ?

Because if you take the 2 spreads, 11-3=8, and the way the spreads are structured, by being Bullish and Bearish at the same time, the Credits are 35 cents more than what you need to pay.

Your account will be credited with $8.35, but the maximum you will lose, whether the stock price goes up, goes down, or stays within 3 or 11, will still be $8 (less brokerage).

This is an classic case of Derivatives Arbitraging Strategies, employed by market makers, Hedge Funds, and probably some other Banks that had gambled with your money and lost it all.

Now you may still be puzzled at what the heck I am talking. I shall not continue explaining how a Box Spread works though, you might need to work out what is an option and how they work. Go figure it yourself.

For every $800 (x100 shares) risked, I gain $35. Pump it up by 5x, it will be $4000. I had executed a trade at 5x on the 2 spreads, netting me a total of $4175. With a surplus of $175, Minus away $100 worth of trade comms, assignments, exercises, I definitely will still be left with about $50+ at least.

Shit Happens?#1 On 26 May

As a newbie, I thought the options will just expire worthless and happyily make my $140. NO! I was wrong. My -$3 Call Options was assigned, leaving me with a Shorted Stock at $3, when the stock is trading at $7++ $8. Nevermind, because the moment the Call option was assigned, my account is credited with cash of $2450++. Now because I was margin called (stupid. Forgot the margin as I have a few more of this same strategy executed.)

I immediately Covered at $8.18. Executed this trade at $7.93, now covered at $8.18, I had a lost of roughly $150 (Lost #1). Sure immediately Covered at $8.18 for a $3 stock, after thinking thru hard, I opened another Box Spread, this time, no arbitrage @ $7.

So a $7 Call written / $7 Put bought, leaving me with:

-Sell Call at $7 – Credited with $1.46 (Stocks @ $8.2x)

-Long Call at $11 – Debited with $0.38 (Out-of-the-money)

-Short Put at $11 – Credited with $4.10

-Buy Put at $7 – Debited with $0.30 (Out-of-the-money)

-Put at $3 – Debited with $0.30 (Out-of-the-money) (Eventually Sold off, Loss #2)

Shit Happens #2 on June 16

CHBT Trading Halted @ $3,46. Stocks and Options markets halted all trading activities for this stock. Well, this Box Spread strategy was “prepared” at events like trading halts, as we are bullish and bearish, Neutral on price movements.

On June 17

Without fear, I only had one choice to do (Its 12pm noon now in US market time and Im sleepy..). With the disabling of automatic exercising from OCC, I have to instruct my Broker to manually exercise away the $7 Put (Why not $6 not $8 strike ? $7 Was the cheapest). Worst case scenario is that they cannot exercise and not give me a short stock. Why ? I have an obligation to Buy Stocks at $11, given the Short Put, and that too many Naked Puts Holders, and not enough shares to “deliver”

A Good write up here what happens?when Trading Halts and you have A Put Option:

http://whatheheckaboom.wordpress.com/2011/03/16/dangers-of-owning-puts-without-owning-the-stock/

What happens to the Call Spread ? They have done what they are suppose to, hence Bear Call Spread. Both Calls expire worthless, and I get to “pocket” the Credit Calls $.

As for Put… ?

Worst Scenario #1

Tomorrow will be the options expiration day. By Tomorrow, I am suppose to be -500 shares. If somehow the exercise screws up, and I couldn’t be short 500 @ $7, and I ended up buying 500 stocks @ $11, I may have to sell only after the stock re trades, at probably $1 ? Pure N00b OwN4ge.

Ideal Scenario #2

I will have my Puts Ex0rcised, and the other party (who sold me the $11 Puts) will exercise his Puts, and I will be Net 0 Shares. Simply Buying @ $11, and Sell @7, I will offset my risks to the guy that Sold me his $7 Puts. At a Loss of $4, don’t forget initially I have sold and credited a Put at $4.10, and bought the $0.30 (Loss #2) as a Bull Put Spread + My credit at the Call Spread. So I am losing abit of here and there (Loss #3)

Best Scenario #3

The Noob at the other end, $11 Put, did not exercise his shares, while I exercised mine, resulting in a Short 500 shares @ $7. ?Anytime the market opens and resume trading (usually down slightly) I will earn by selling @$7, buying at the Open market (Hopefully on Pink Sheet/OTC). Else, I have to hang onto a -500 Shares for no reason.

Tomorrow will be June 18 and Expiration Day. I am crossing my fingers not to have #1, praying for #2 and hoping for #3 !

On June 19

Ah, finally I was assigned, and exercise for a 11-7 spread. losing $4 x 500. I hope the seller of the put is covered. Made a small $300 loss, that came from the cover of stocks and initiaion of new $7 Put.

Did I mention you exploit this with ‘DEER’ … Hmmm

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In any types of investment, trading or money making strategies, I constantly apply same principles repeatly. The idea is to filter out things that doesn’t work based on these investing principles. Though my experience is limited, I hope this should have be shared in common and considered.

These 3 principles, or rather 3 levels of difficulties/challenges, have guided me through till now, and allowed me to explore new stuff, from portfolio management to juicy hedge funds, Equities to Derivatives and its back to the Basic Fundamentals of investing.

1. Beat the S&P500

I have seen many retail traders that have failed big times and quit. Having been thru some of the “fantastic” stuff on trading and investing, have you ask yourself, “Have my analysis and skills beat the market (S&P500 or any of your traded market index / strategy)”

If your answer is an obvious No, I prefer you to stay with the Index for the least. Chances are most investors keep only a handful of stocks in their portfolio, and most have the “100% Cash Equity” ready to bet on a commonly known strategy called “Directional Speculation”. In short, “Gambling”.

If you manage portfolios, you can easily, with Google Finance, add a handful of stocks, probably a good 5-10 stocks, measure it with S&P500, and see how it fared. Likely, if your selected stocks average performance doesn’t beat the market index, forget about putting money into Stock equities. Buy the index.

The use of Index Funds would be one good way to perform equally well with the index, profiting from any dividends that it pays out too. Many Mutual funds, ETFs, or advance tools like Futures Contracts should allow you to follow the market index.

2. “Hedged” Fund

The idea of hedging is similar to buying the index, where you try not to under/outperform the market index. Problem is “What if the S&P500 slumped 10% in a single week ? What are you gonna do?”

To “hedge” your own fund is to slow down the bleeding and increase the food. It is OK to gain only 2% when the S&P500 added 5% last month (though you lag the market by 3%). But, if the market drops 8%, you should at least not lose that much, and probably even better if you don’t lose at all. (though you don’t really gain, you don’t lose that much”

That definitely sounds very difficult, but the general principle is not to lose as much, and sacrifices that last bit even if you don’t gain as much. This is somewhat similar to lowering your risks, while lowering returns, but when you can manage and offset that risks, the last part of your job is to increase returns.

Some suggestions for hedging:
- Long/Short your stocks for a very bad and volatile market.
-Portfolio insurance with Derivatives, buying Puts or selling Calls.
- buying lower beta Stocks (low volatility) or inverse asset instruments (eg. Stock Equities vs Bonds, Currencies vs Commodities, diversified sectors that don’t correlate with each other well)

3. Arbitrage

Finally, after 1 and 2, the term “Arbitrage” is simply so strong and powerful and usually rare, that most traders don’t talked about it (Who will provide courses to teach you how to make money?). Yet, its the only way to survive in a market. Find your own Edge, Alpha, and you are on your way making money at an almost risk free rate.

You often hear brokers selling trading ideas, but none, I say None, are on how to arbitrage the markets. Also commonly, even Failed traders (Sorry if I got you) rely simply by drawing Straight and Curvy?lines over more lines (Candle Sticks analysis?) expect to make money for a living. The markets are not that easy, until you can even master Principle 1 and 2. Even so, you are almost only as good as Day 1.

This part of the principle has gotten deeply into me, exploring other instruments, methods, learning more Maths and formulas (Quantitative analysis they call it) and finally some of the Basic rules.

The common rules, “The Fundamental Law of One price”, the “Pair/Spread trading”, and lastly the one you’ve always heard “Buy Low Sell High”, find it and practice them well.

For now, I shall keep that a secret (do you see magicians tell you how its done?) for you to find out more on this principle, but as a common phrase,”Its either you have it or don’t.” I referred it to the business sense in profiting risk free gains, exploiting prices differences and discrepancies, and you will “find” it if you work hard enough.

Maybe, maybe for a start, practice on Point 1 and 2 and try not to lose money.

Dennis

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