37 lines
2.7 KiB
Plaintext
37 lines
2.7 KiB
Plaintext
Chapter 27: Arbitrage 455
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expensive with respect to the other one, historically. Then, when the stocks return to
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their historical relationship, a profit would result. In reality, some fairly complicated
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computer programs search out the appropriate pairs.
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The interest on the short sale offsets the cost of carry of the stock purchased.
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Therefore, the pairs trader doesn't have any expense except the possible differential
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in dividend payout.
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The bane of pairs trading is a possible escalation of the stock sold short without
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any corresponding rise in price of the stock held long. A takeover attempt might
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cause this to happen. Of course, pairs traders will attempt to research the situation
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to ensure that they don't often sell short stocks that are perceived to be takeover can
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didates.
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Pairs traders can use options to potentially reduce their risk if there are in-the
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money options on both stocks. One would buy an in-the-money put instead of selling
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one stock short, and would buy an in-the-money call on the other stock instead of
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buying the stock itself. In this option combination, traders are paying very little time
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value premium, so their profit potential is approximately the same as with the pairs
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trading strategy using stocks. ( One would, however, have a debit, since both options
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are purchased; so there would be a cost of carry in the option strategy.)
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If the stocks return to their historical relationship, the option strategy will
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reflect the same profit as the stock strategy, less any loss of time value premium. One
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added advantage of the option strategy, however, is that if a takeover occurs, the put
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has limited liability, and the trader's loss would be less.
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Another advantage of the option strategy is that if both stocks should experience
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large moves, it could make money even if the pair doesn't return to historical norms.
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This would happen, for example, if both stocks dropped a great deal: The call has lim
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ited loss, while the put' s profits would continue to accrue. Similarly, to the upside, a
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large move by both stocks would make the put worthless, but the call would keep
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making money. In both cases, the option strategy could profit even if the pair of
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stocks didn't perform as predicted.
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This type of strategy- buying in-the-money options as substitutes for both sides
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of a spread or hedge strategy - is discussed in more detail in Chapter 31 on index
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spreading and Chapter 35 on futures spreads.
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FACILITATION (BLOCK POSITIONING)
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Facilitation is the process whereby a trader seeks to aid in making markets for the
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purchase or sale of large blocks of stock. This is not really an arbitrage, and its
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description is thus deferred to Chapter 28. |