Having understand some of the simplest investing principles and management, and after playing around with derivatives, I am back to the most simplistic form of trading, as a business.

I wish that I could have started off with this, given my skill sets, but after losing like 30% of my own money down, in exchange for some valuable experience, I think it is worth it. Algo trading, black box trading, or some I would call it low frequency trading (doesn’t involve anything below 1ms) involves the use of computers to make decisions, cut losses, and etc.

And what can I say, there’s a reason why there’s vending machine and why I started vacuuming the floor with “Neato”

Just something I made up hehe:

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What a crash. I haven’t seen something like this thru my trading life, because I started after the 2009 Lehman brothers crash. My Portfolio took a hit, unhedged, and some losses were inevitably taken, portfolios readjusted.

Keep it short, some points to note, things learned, actions taken:

- Vix Shot above 25.

In my style of investing, anytime when VIX goes above 25, I have to cut the volatile stocks, keep some cash, and neutralize some beta of my portfolio by being short some stuff or the S&P500 Index.

- Credit downgrade of US Treasuries.

Before the actual announcement, somewhere near end of July, there were already news that mention some US Bonds might default. And it was getting serious because politics were involved. I started to readjust All Funds that contain that bit of US treasuries, especially those from PIMCO HIGH INCOME Fund and some others. Losses taken here

- Big volatile day movement of 5%, up or down.

I had been playing around with Options Trading and strategies, and I would agree with those Futures traders and why people trade Futures, such as the ES Mini ?S&P500 contracts. Some disadvantages of Options during Volatile times:

• Costly – More trades or higher quantity means more Fees
• Complex – Here are many factors that affects its pricing. (Demand/Supply)
• Spread – Yes, this is one other factor. You might be right… but
• Time decay – This also affects too.

- Markets are interconnected – Time to move to Futures

And as you all know, there are so many markets and Index trading around the globe, from Nikkei 225, Hang Seng, to UK’s FTSE and Stoxx, and to S&P500. I don’t want to complicate with Commodities and Metals. With the advantages of Futures trading (you will know the differences between Equities /Options / Futures if you trade long enough) and the ability to go long and short cleanly, it is really a overall Huge market. Time to move a part of my strategy to Futures trading, but hedging comes first as priority.

- Portfolio Adjustments

With the cutting of treasuries funds, money was allocated to REIT (after the even extended time for low Fed rates). Corporate debts were also cut, since it is more logical for companies to borrow from banks instead from Wall St. Some late Night Shopping was done, Stocks I wanted to own 6 months ago are now inside my Portfolio thanks to a verb called “Patience”. I have also doubled down on some World / Asian Equities, and since the rebound, they are almost back to the green . Some Funds were also allocated to Foreign Government Bonds too as my safe Haven.

- Currency Hedging

I also took this time to add a new “feature” as I have using SGD (Sing Dollars) to trade the US Exchange, hence I need to convert to USD. For every 10k I have converted, I’ll be hedging 10k worth of Shorts USD / Long SGD, to take away this currency Risk. This will be managed by Spot FX.

- Losses

I’ve taken about only 2% of losses at equities, but close to 7% for derivatives. having realize this, I am a level up on the use of Options, its Leveraged power, and its disadvantages.

This is a snapshot of my portfolio as of 16 August, the day after Google bought Motorola for 12Bn.

Manage money online trading Portfolio 16 aug 2011

This was taken from Google Finance, since my Equity Portfolio can be easily manage while I concentrate on other Strategies. Perhaps this will be updated every quarter

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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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Similar to a Covered Call strategy, a Covered or Protective Put works the same way, except its the opposite, but both of these trades actually credits you cash. But when is a good chance to exercise this ? When Investors fear and the more fear the better. Here’s an example:

Looking over a counter called DEER, its a China Company that’s listed on NASDAQ.

1) Fundamental:
There were news and rumors about this company, by a blogger over at Seekingalpha.com. Now this Company is actually suing over that particular guy who wrote about suggested shorting this stock, due to bad earnings.

2) Technical:
Since Mar 21, the stock has been heavy sold/shorted from $9 to $6 +, with a very nice smooth downtrend, suggesting the selling was gradual and controlled, not much panicking here, but people simply don’t know the situation.

Using Slow Stochastic Oscillator (SSTO), the points to short are when it hits above 80-85, and using Bollinger Band, the width of the upper/lower envelope shows the stock price isn’t jumping around randomly but a gradual one, suggesting it isn’t that volatile.

For stock DEER to average $11 for 5 months, drops sharply to $9, and go under $8 in 2 weeks, it means Investors are fearful.

Here’s the trade.

When the stock was around $6.60, 6 Apr 2011, the Options market, particularly the Put options for $7.5 strike, was trading at $1.85. That means that if you short the stock at its current $6.60 (to buy back at $7.50), and write a put at $1.85 (for $7.5 strike), you will be “credited” net at $6.60 – $7.50 + $1.85 per share.

If you decide to trade 500 shares:

Short 500 @ $6.60 = -$3300
Sold 5 Put @ $1.85 = -$925
Total profits (If exercised at $7.5) = ($6.60-$7.50) x 500 + $925
=(-$0.90 x 500) +925
=$475.

If the stock prices shoots up strongly, with news or buy backs, you make a lost on the shorted $6.60, but your $1.85 a share is theoretically enough to cover $7.50 – $1.85 = $5.65.

If the stock prices drops sharply, with more bad news, it doesn’t matter, because you have already covered the shorted stock with a buy back at $7.50 put, because you are a writer, obligated to buy the shares from the put option buyer. You are bound to lose 90 cents, but your $1.85 would be nice enough to cover that.

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Gempa-Dan-Tsunami-Jepang-20112

Gempa-Dan-Tsunami-Jepang-20111

I have watched in horror when BBC news aired the destruction at above 4pm Asia Time. Onto Cnn.com’s video segment, what I saw wasn’t an 8.9 magnitude earthquake. Its the strong current, huge amounts of water pushing through roads and streets. Water current by itself is harmless, but when you have lots of it, it becomes an unstoppable force.

And I don’t need to repeat what is happening now, the Nuclear crisis. It has caused massive fleeing, and in short, affects the economic developments in Japan. Not to mention the rescue work that is still being done and snow is preventing work from going smoothly.

Now back to managing money and trading. If you had shorted the Nikkei Futures, you would have made quite handsomely. Looking at over the US listed stocks on Japan companies or Asia related stock price, it was shocking to see most of them shed at least 15-30% .

Shorting with the Japan Index wasn’t that difficult. By buying a few puts on iShares MSCI Japan Index (ETF) (Public, NYSE:EWJ), which tracks the Index for Japan, you are actually betting that the index will go down. But because this is traded over NYSE which is on US timing, it somewhat reflects both “today” for Japan, and speculating for tomorrow’s open. A peek over Nikkei 225 Future’s would give you a rough idea how the market will open, since most worldwide economic news would have been overshadowed by the uncertainty in the series of events.

And lastly, I hope things are okay for Japan and Asia, and hope they’ll pull through.

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Well, firstly if you are an active trader and watch the market everyday, you would have know about the Egypt unease, followed by Libya. In fact Libya’s case was more serious.

Now back to Dollars and Cents topic. What could you have done when the prices went irrational ? Back these few days I had put up a few trades some of which would in my opinion, chain effect and trigger other events.

Well first thing first, on Feb 23 I actually Long Crude Oil near the $96 mark, not in the Light Crude Oil Futures, because I do not have access to Futures market yet. Instead of that, I had use ProShares Ultra DJ-UBS Crude Oil (Public, NYSE:UCO) . And on top of that, in order to minimize and set my Loss limits, Options on equities were used. Just speculative, I long 4 Call Options, held over night, was happy when Oil prices touch at $103. Then I cut it at $100 on Feb 24.

Its a great tool when you are uncertain and want extra leverage when you have the odds. Well even so Saudi Arabia had enough Oil supplies to cover Libya, we all know humans are irrational. (I was lucky to set stop loss at $100 when there were rumors Libya governing leader was shot. Prices came crashing down after that.)

Now next few stuff you could look at when Oil prices goes higher.

Short companies that relies on Crude Oil

Not to mention any stock tickers here, but generally you could open small Sell Short positions on some of the worst performing companies in these industries
- Airlines
- Logistics (DHL / Fedex similar)
- Any other industries you know off that relies heavily on Oil Prices as expenses

Probably for starters or other investors, we should look at things in a few ways.

Fundamentals – The fundamentals suggests that if the higher the Oil prices, the higher the cost of operating a business. And as such, profits are being eaten into, and thus results in lower earnings. Also you definitely wouldn’t want to short an airliner / air carrier company that’s in the Top 3 in the US or Europe Business.

Technicals – Just based on technical charts, you wouldn’t want to short a stock that has gone in a steady nice uptrend. Why ? Because it suggests that this company might be doing great, and would be able to overcome this Oil price increase. Short a company that has been holding and having a downtrend.

Quantitative trading – Well, I made this up. Yeah you have shorted a stock, odds were in your hands. You had a 5% gain and now what ? Other other traders and investors would be probably buying Puts Options to protect their positions. Now if you are happy with the gains, sell or write puts instead, forming a Protective Put strata. You have just limited your gains, but at the same time, gaining extra profits should the price stay in that range.

Or yes Quantitative again – What if you could “hedge” against these short(s) positions ?
What about going Long on Companies on that relies on Oil prices to profit ?

Long companies that relies on Crude Oil as products

Now you have your shorts, and you have Money, I mean real hard cash in yer account. Now use this to Long.
- Oil product sellers
- Oil Miners, productions
- Any other industries you know off that relies heavily on Oil Prices as income

Some examples Exxon, BP, Stone Energy.

Fundamentals – The fundamentals is simply that if last week, I am selling a product for $5000, and suddenly, by doing nothing, I get to sell a product at $6000 without incurring extra expenses, that is what I call free “Profits”, and it just happened to Crude Oil commodity asset class.

Technicals – Just based on technical charts, you name it. Buy in some of the best companies, and they simple go higher. I seriously would be blind-folding myself and buying in.

Quantitative trading – Well I don’t see any in this deal, except probably you could use Call Options to trade up, or simply, by hedging the Short positions for these Long.

Well I guess you have to practice until it becomes nature and react fast enough. Oh yea, Happy trading !

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Many of us retail investors do not know much of the entire financial industry itself. I would like to remind retailers that yes we do feel great to pick and buy our stocks that we’ve looked at so long, love the way the numbers jump and talking to someone your end of month performance.

I would love to cover this in another article about what retail investors should look out for instead, but if you are savvy enough, my guess is eventually you’ll reach this stage.

This video is called “Hedge Fund Strategies Without the Hedge Fund”, and its right here:

http://www.finweb.com/videos/index.html?297729317

Well in summary, replicating hedge funds is all possible now, compared to last time. BUT, replicating hedge fund returns would be difficult. ie. Shredding 24% total of $ 600 Million, or revving up 40% on some bets raking in $2.1 Billions on some bets. That would be difficult if its based on our small $100,000 seed capital.

Finally, it all depends on knowledge, research, skills, and instruments/tools/products we have access to, such as long / short equities, bonds, swaps, options, futures, global macro investing, short bets, hedging and arbitrage.

Well cover more of stuff for retail investors. Happy Trading!

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As of today, Citigroup shares stood at $4.77 after hours.

The idea is to use Options derivatives to trade its shares and hopefully earning a small risk free profit, though there are still risks involved.

This is what I think is called “Calender Bull Spread”.

Heres the example that I have actually traded (Taken from Yahoo Finance):

Option pricing for C Mar 2011:
4.00 0.85 Up 0.07 0.85 0.86 9,098 289,566
4.50 0.49 Up 0.06 0.48 0.50 4,525 216,261
5.00 0.25 Up 0.03 0.24 0.25 26,869 327,288

Option pricing for C Jan 2011:
4.00 0.80 Up 0.10 0.78 0.79 25,408 946,186
4.50 0.38 Up 0.06 0.37 0.38 39,751 585,347
5.00 0.14 Up 0.02 0.13 0.14 104,742 2,410,326

The idea:
To buy In-The-Money Calls at March, and sell Out-of-the-Money Calls in January.

Based on the volume, we see the Jan 2011 $5 Call is very much traded up, causing the value to go up.

And to play safe, a $4 ITM Call is bought, because I guess it is unlikely the shares of Citi will drop below $4 by Mar 2011, with the Fed already clear their stake of Shares to the open market. (I am bullish on this, hence the name Calender Bull Spread)

So let’s do the Maths (Excl. Commissions):

Buy Jan 2011 $4 Call @ 0.86 x 20 calls = $1720
Sell Mar 2011 $5 Call @ 0.14 x 20 calls = – $280

$1720 – $280 = $1440

1) The ideal situation is Citigroup shares went above $5 by Jan 2011.

You’ve spent $1440 on a $4 Call that you can exercise anytime, or simply 72 cents a share. Now Citigroup is trading @ 4.77, and you’ve got an option to buy at $4 with 0.72 cents a share.
How nice ?

Next the real thing is if it goes through $5, and got exercised:
$5- $4 = $1 * 2000 would give you $2000. This is the profit “spread” you will have if its exercise.

Now take $2000 + $280 – $1720 = $560. This is the profit less the expenses.

2) What if it doesn’t go to $5 … by Jan ?

No worries, you have 2 more months. and you’ve just pocket $280 worth of options. Try selling this again in Feb and Mar. Remember the $4 Long Call Options still has value, in case something happens, you still can sell it off.

If you sold $280 x 3 for Jan, Feb, and Mar, and then selling off the Long call then you would have earned :

$840 / $1720 = 48% “interest” ROI

Based on the $1720 you’ve spent.

So why does this happen you may ask ?
The reason why this opportunity exists, all because the calls were slightly overpriced resulting this Relative value arb.

- The $5 Jan 2011 calls were to optimistic. The value went up, and so you Short the overpriced.

- Decided to buy a $4 Call because it simply cost 0.85 cents, just 8 cents higher than 4.77, and so you Long the “fairly priced”.

You may buy a $4 Call at May or August, but it may be slightly higher, probably $0.95, but its “Delta” is not gonna be priced higher (a 20 cents move in stock means a 20 cents move in Options value for March, as opposed to 20 cents move in stock with a 22 cents move in the Options value in August)

And if all doesn’t work well. Simply write/sell a $4.00 Call at March. You won’t lose much.

Disclaimer: I own shares of Citigroup, that is why I bother to look at the Options book =)

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This is yet another possible arbitrage way to profit, if you are good with Maths, and CAPM short for Capital Asset Pricing Model.

Taking out the expected return which is random, we are have variables for the stocks metrics, in stock price and stock beta or its sensitivity.

Assuming the Law of One Price states that 2 similar assets classes should have the same prices, one could possibly exploit the pricing differences through a number of reasons.

Now let’s say I have yet another pair of stocks called DPO and DDM.
(Taken from Google finance, its description)

DPO:
Dow 30 Enhanced Premium & Income Fund Inc. (the Fund) is a diversified, closed-end management investment company. The investment objectives of the Fund are to provide a high level of premium and dividend income, and the potential for capital appreciation. The Fund pursues its investment objectives principally through a multi-step strategy. The Fund will purchase the 30 common stocks included in the Dow Jones Industrial Average (DJIA Index), weighted in approximately the same proportions as in the DJIA Index (the Dow Stocks). The Fund will also purchase other securities or financial instruments, primarily swap contracts, designed to provide additional investment exposure (leverage) to the return of the Dow Stocks (the Additional Dow Exposure). The Fund also will engage in certain option strategies, primarily consisting of writing (selling) covered call options on some or all of the Dow Stocks (the Options). The Fund’s investment advisor is IQ Investment Advisors LLC.

DDM:
ProShares Ultra Dow30 (the Fund) seeks daily investment results that correspond to twice (200%) the daily performance of the Dow Jones Industrial Average (DJIA). The DJIA is a price-weighted index maintained by editors of The Wall Street Journal. The Index includes 30 large-cap, blue-chip United States stocks, excluding utility and transportation companies. Components are selected through a discretionary process with no predetermined criteria except that components should be established United States companies. The DJIA is not limited to traditionally defined industrial stocks, instead, the Index serves as a measure of the entire United States market, covering such diverse industries as financial services, technology, retail, entertainment and consumer goods. The Fund takes positions in securities and/or financial instruments that, in combination, should have similar daily return characteristics as 200% of the daily return of the Index. Its investment advisor is ProShare Advisors LLC.

Now assuming both the shares track the DJI index or the 30 DJI component stocks, we should achieve the same pricing. But because of the asset value and no. of shares on the open market, they are priced differently.

Lets take a look at how to track them to the similar pricing:

With A as DPO, B as DDM, and only the prices and beta are used here:

A = DPO, $10.24, 0.88
B = DDM, $ 49.28, 1.83

A = (A1 * (1/0.88) = 1.136A1)
B = (B1 * (1/1.83) = 0.54B1)

If A = B (Law of one Price if it exists)

(A1 * (1/0.88) = 1.136A1) = (B1 * (1/1.83) = 0.54B1)
substitute with pricing:
A1 = 10.24
B1 = 49.28

Introducing X and Y to get the proper no. of shares, and multiplying Stock beta with share price:
X(1.136* 10.24) = Y(0.54 * 49.28)

X(11.63264) = Y(26.6112)

11.63264/26.6112 = X/Y

X/Y = 26.6112 / 11.63264

X = 2.28
Y = 1

***
For every 100 share of DDM, we should have 228 shares of DPO to be neutral eg. Long/short or market neutral strategies.

EG:
10.24 * 228 = 2334
49.28 * 100 = 4928

With a 1% movement of DJI, DDM should move 1.83%, while DPO should move 0.88%. But even so, the share value of $2334 and $4928 cannot effective reflect this because:

Even with the right 228 / 100 shares

0.88% x $2334 = $20.53
1.83% x $4928 = $90.18

We need to bring the “Price difference” value to be “equal” or equilibrium.

Taking 90.18 / 20.53 = 4.39

It means the value difference is 4.39 of ratio.

Take 4.39 * 2334 (which is also 228 * 4.39) to bring the “difference” value of DPO closer to DDM.

10.24 * 1000 = 10240
49.28 * 100 = 4928

Now, if DJI moves 1%

0.88% x $10240 = 90.112
1.83% x $4928 = $90.18

So in order to create a “hedge” portfolio, or in finding arbitraging opportunities, we should buy 1000 shares for every 100 shares, at that price of $10.24 and $49.28 respectively. This, unfortunately, only exists in theory, since prices are always fluctuating with demand and supply.

We could use a filter such as Bollinger Bands to filter the upper and lower prices and get the average for the long term instead. One scenario I could think of is this (since DPO regularly gives out huge dividends):

Long DPO, Short DDM
but Long more of DPO instead since the beta is lower and it gives out dividends.

Try at your own risk !

Disclaimer: No positions on above mentioned Stocks

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