On selling short: short poem for Paula

Jordan Hayes jmhayes at j-o-r-d-a-n.com
Sat May 22 10:09:06 PDT 1999


From hliu at mindspring.com Fri May 21 17:24:11 1999

As the following table shows, most shorts are part of an

arbitrage strategy.

I don't understand how "the following table shows" that "most shorts are part of an arbitrage strategy" ...

In looking at a table of hedge fund strategies, you must remember that nearly all self-styled 'hedge-funds' (as misused of a term these days as 'think-tank') have one thing in common: their prospectus specifically allows the manager to short financial instruments. Many of the biggest mutual funds are not allowed to short anything. So this table doesn't show any relationship between shorting and arbitrage. All of these strategies involve, at times, shorting. It's only the "short only" type of fund that places any real significance on shorting at all. Once you're allowed to short, the question of how to make money becomes, in a sense, easier: if it's going down, short it; if it's going up, go long.

Getting an education in anticipation of high future income is

an act of arbitrage. Aiming for longevity in hope of a better

future in also an act of arbitrage.

I think you need a better definition of arbitrage; neither of these two examples qualify. The key aspect of arbitrage is risk: arbitrage captures, relatively risk-free, the disparity in pricing between two or more markets. A non-market example I noticed the other day is that if you buy a 'meal' at a fast food restaurant *plus* an additional sandwich, you can change the overall price to your advantage by choosing the 'meal' with the greatest package discount. As an example, note the following prices:

Quarter Pounder $2.89

Quarter Pounder Meal $3.99

Big Mac $2.29

Big Mac Meal $3.29

If you buy a Quarter Pounder Meal plus an individual Big Mac, you pay ($3.99 + $2.29 = $6.28) whereas if you buy a Big Mac Meal and an individual Quarter Pounder you pay ($3.29 + $2.89 = $6.18). The items are identical, yet the prices (presumably for marketing reasons) are slightly different. It's up to you what you'll do with all the money you save (and it might easily "cost" you $0.10 just to figure this out, thus eating up, so to speak, all your arbitrage profits), but pricing disparities do exist and can be captured.

Now: 'arbitrage' as a strategy has also been abused. The strict definition includes 'relatively risk-free' -- measuring risk is a tricky business. In our McDonalds example, all the items on your tray (Quarter Pounder, Big Mac, fries, beverage) are the same in the two sides of the inequality -- because of this, the arbitrage in question is not only 'relatively' risk-free, it's 100% risk-free. It's not like if you order in one way or the other that you might wind up with a Filet-o-fish instead. What a bummer that would be.

But how much substitution is tolerable? The most common form of self-styled 'arbitrage' activity in the US equity markets is concerned with the difference in the sum total of all the components of an index (the S&P 500 being the largest and most liquid for this, but any of the indexes can be and are used) and the appropriate futures contract that represents, theoretically, the index (this is called, not surprisingly, "index arbitrage"). These values do not precisely track each other, and at times can become far enough out of whack that it can make sense to try to buy all of the stocks in the index and sell the corresponding amount of futures contract (or the opposite: buy the contract, sell the stocks), capturing the "relatively risk-free" difference. The risk here can be quantified in terms of 'slippage' (the difference between the price that you used to make your decision and the actual price you get at some time later) and, from the looks of the recent program-trading activities (published weekly in, among other places, the WSJ), are still a fertile ground for opportunities. As these markets (the US equities market and the S&P 500 futures market) get more efficient, these pricing disparities are fewer and further between. So what to do? Cheat. Skew your tolerance of "equal" to suit your own technology and risk appetite. Maybe you just buy 450 of the 500 stocks (it's quicker and cheaper, obviously) before you'll be ready to short the future. But then the 'realtively risk-free' aspect of this activity comes back to haunt you.

Even further out, a place like LTCM (and Nick Leeson, for that matter) had "determined" (through whatever pseudo-science was fashionable that day) that two things that weren't the same (in our example, let's use a Quarter Pounder and a Big Mac) *were to be viewed* as being the same for this equation. In our example, you could squint your eyes or move far enough away in space or time (take 10 steps back; can you tell the difference between a Big Mac and a Quarter Pounder? Similarly, think back three weeks: can you remember the difference between eating a Quarter Pounder or a Big Mac?) to make them the same, and thus your preference for either would be neutral. The choice is then obvious: sell what's expensive, buy what's cheap.

The problem of course is that if whatever you used to determine they were "the same" fails one day (like you actually decide you hate special sauce), the equation falls apart and you lose.

The unfair part of hedge funds as they are current constituted

in the economy is that they are by law available only to the

rich ($2-5 million net asset, so call qualified investors) ...

"Qualified investors" have much less than $2-$5M; I think the definition is more like $200k of current year income or $1M of total net worth. But the real barrier to getting in on a hedge fund is that many of the boutique funds don't want small accounts because it's more expensive to manage 1,000 $100k accounts than it is to manage 100 $1M accounts. Also, it's easier to not have to deal with things like redemptions more than once or twice a year.

An average borrower can borrow 2 times his asset (equity), but

hedge fund investors can borrow several thousand times their

assets.

This is misleading; the amount of margin required for the purchase of securities is the same for everyone: hedge funds and housewives alike must put up 50% of a US equity purchase, for example. But access to credit can vary, just as a student and a lawyer can have a different number of credit cards -- it's not uncommon these days for individuals to have access to credit lines that represent many times their annual income or even net worth. As a simple example, real estate is often available to non-high-net-worth-individuals for 3% down these days.

So the large fund may have access to credit lines that allow the purchase of securities that add up to a net value that far exceeds their asset base. The leverage involved in certain kinds of securities can be much higher, and even you can buy a futures contract with only a 10% margin requirement.

Reports of the rich getting richer even during the global

financial crises is due to the fact that most money making

channels in the markets are opened only to the rich (in the

name of protecting the poor who cannot afford to lose).

It's even worse than that: I saw a report the other day that said that in the US blacks have not participated as much as whites in the spectacular rise in the stock market because, for a variety of reasons (one mentioned is they, statistically, *don't trust* financial advisors!), they are under-represented in the equity markets with their investments. So given two people, one black, one white, who started out this bull market as financial equals, the white one is further ahead today.

/jordan



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