Minyan Mailbag: A Short Volatility Trade
...taking an aggressive stance on a spread with limited value and leveraging it up.
I don't know if you have said anything about this, but merger spreads seem incredibly small to me. A couple of stocks we owned, JAMDAT Mobile (JMDT) and Micromuse (MUSE) had incredibly small spreads. JMDT traded at the cash offer price so we sold out. MUSE is trading at $.20 on $10.00. Am I imagining this or have you noticed it also?
Thanks as always,
This is another example of a short volatility trade: taking an aggressive stance on a spread with limited value and leveraging it up. This is a function of risk taking: the willingness to take more risk for less return.
Everyone is starving for income. So they take more risk in trying to get it. They begin looking at capital risk (potential loss) as a function of income (selling calls is viewed as income).
And that is what is driving markets: investors willing to take more risk have eliminated any risk premiums that exist in the market. Asset prices of risky assets are bid up.
Almost every hedge fund strategy is now geared to a short convexity pay-off profile. This has compressed markets.
Being bullish or bearish on fundamentals is insignificant to the risk premium people assume in driving asset prices.
This is the basis of our view: risk premiums are at a secular low (as encouraged by all monetary and fiscal policy) and the system is set-up short convexity; the unwind of this, the unwind of the unprecedented credit expansion and liquidity will lead to increased risk premiums and increased volatility.
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