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Long, short, or put?

August 12th, 2009 Leave a comment Go to comments

As you know, I recently started investing in a quantitative equity portfolio. I’m a big fan of long-short strategies (on paper at least!). For folks that aren’t familiar with the term, it refers to strategies where investors borrow stocks they think will do poorly and sell them in the market. They then use these funds to buy stocks they think will do well. Later they sell the stock that hopefully did well to realize a profit, and then buy back the stock that hopefully did poorly at a discount to what they got for it when they sold it, and finally repay the stock loan. For example, suppose both Stock A and Stock B are currently priced at $100. It’s my belief that Stock A will do very well over the coming month and that Stock B will get decimated. In this case I short Stock B – that is, I borrow it and sell it in the market for $100. I then use that $100 to buy Stock A. Note, there is no investment of my own money at this point (ignoring transaction costs, that is). Now, suppose that one month later Stock A is trading at $110 and Stock B has fallen to $25. In this example, I was correct about both stocks. In this case I would sell Stock A for $110 (realizing a profit of $10, since it cost me $100 to buy), and I would purchase Stock B for $25. At this point my net cash position is the $110 I got from selling Stock A less the $25 it cost me to buy back Stock B, for a total of $85. I now return Stock B to the person I borrowed it from, and the transaction is done (again, ignoring interest cost for borrowing Stock B). I invested $0 of my money in the strategy and walked away with $85! Note that I could also have just invested $100 in Stock A since I thought it would go up. In this case I would have made $10. The short transaction in my example simply augments my income if I am correct.

As a side note, note what happens if I’m wrong. What if I though Stock A would tank and Stock B would rise. In this case I’d short Stock A and buy Stock B. One month later I’d sell Stock B for $25 (for a loss of $75, since it cost $100), and I’d buy back Stock A for $110 (for a loss of $10, since I got $100 when I sold it) and repay the stock loan. My net cash position is $25 from selling Stock B less $110 for buying Stock A, or a total loss of $85. I invested nothing and lost $85!

Back to the portfolio… I had intended for it to be a long-short portfolio where I’d buy the names the model thinks are the best, and sell those it thinks are the worst. After looking through some recent data I realized that I could lose as much as 10% of my portfolio in two weeks doing this (if the short stocks take off), and so I decided against that. However, I really wanted to incorporate the model’s views about poor stocks into the trades. One way to do this is to buy put options on the poor stocks. Again, for those not familiar, a put option is basically an option to sell a stock at a pre-determined price. If Stock B is trading at $100 now and I think it’ll be at $50 in a month, I can buy a put option struck at $100. That means that I now have the right to sell the stock at $100 at some time in the future. Now, a month later if the stock does go to $50, I can but it in the open market for $50 and then exercise my option to sell it to the person who sold me the option at the strike price of $100. This would result in a profit of $50. Note, the option is not free, I would have had to pay for it when I bought it. The price depends on many factors, but would have certainly been much less than the $50 profit. On the flip side, if Stock B rallied, I simply choose not to exercise the option. I don’t make any money, and my only loss is the premium I paid to buy the option. You see how this can be more attractive than naked shorting – when stocks really take off, my losses using a put option are limited to the premium whereas my losses from shorting are unlimited.

In case of my portfolio the options would allow me to bet on the downside. The problem here is that a single option contract is for 100 stocks. That is, they are sold in bundles of 100. So, if it costs $5 for a single stock option, I’m forced into buying 100 for $500. This is an issue for two reasons: 1) I need a lot more money up front to buy the options, and 2) if the stocks take off, I have a lot more premium to lose. In my case the total premium for a single contract on each of the stocks I wanted to short exceeds the total amount of my portfolio, so it’s just not doable. Yes, it is true that if I’m right and the stocks in question tank I’ll make a lot more money, but the risk is just too high right now.

So, it seems as if I’ll have to forget about the short side of the equation for now and just place my bets on stocks I think will go up. However, it does leave us with some food for thought: if options limit losses in case the stocks take off, why would I ever short?

The answer lies in the cash. When you short a stock, you get money equal to the value of the shorted stock, and your payoff is inversely related to the stock (for each dollar the stock makes you lose a dollar and for each dollar the stock loses, you make a dollar). With options you still get an inversely related payoff, though it’s generally less than one (that is, you won’t make a dollar for each dollar the stock loses. Rather, your payoff will depend on the delta of the option, a detail I’ll save for a later post). The other key difference is that when shorting a stock you get money, but when buying a put option you pay money (the option premium).

In a long-short portfolio of $10,000, you short $10,000 worth of stock and use that money to buy $10,000 worth of stock, leaving you with $10,000 of cash. You can then either keep this cash and earn interest on it, or you can invest it in a benchmark like the S&P 500, or do whatever else you want with it (a sort of portable alpha strategy). The nice part here is that if you’re wrong about your calls on the long side or the short side, you still have the investment in the benchmark to diversify away some risk (assuming you used the extra $10,000 to but the benchmark). However, if you had used options, you would use part of your $10,000 to buy options and the balance to buy the long stocks. Here you have two negative effects: 1) your total investment is less than the long-short (since you’re long fewer assets and you have less short exposure, ignoring contract size for a moment), and 2) you have lost the diversification benefit of owning the benchmark. Your entire return is based on your long and short calls, which may or may not be correct. So, now you see the cost of going with the put option – yes, your loss is limited if the “short” stocks take off, but the price of that is a smaller position and less diversification.

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