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Minyan Mailbag: Harvard Campus Tour


You will find many of your good questions have already been answered in more detail in the nearly 10,000 articles written by our professors.

Prof. Succo

My name is Kevin and I'm currently a freshman at
Harvard University. I went to your presentation and wanted to ask you a few questions afterward, but I unfortunately had to run to a meeting and get some work done. I fear some of these questions could have been answered more fully in person, but I figured I'd ask them anyway. Please answer them at your leisure, and don't feel obliged to answer them all (or even, at all) if time does not allow it.

1) Aside from variability plays by buying stock and puts, convertible bond arbitrage, and equity over-writing, what are a few of the other notable/popular strategies that hedge-funds employ?

2) When over-writing an equity position and "rolling it up," what are some of the variables that one could tweak in order to make the position more aggressive/risky (and how would you tweak them)? Perhaps selling out-of-the-money calls with a smaller time premium?

3) If I'm currently bearish on U.S. equities, rather than simply shorting the S&P or moving all my capital into gold and timber, would it make sense to short the S&P and go long S&P calls in order to reduce risk? More specifically, would this strategy be akin to over-writing but in the other direction?

4) What sort of strategy would involve shorting a put?

5) Option-pricing models depend largely on averaged volatility of the issues in question. How, then, are imminent mergers/acquisitions/spin-offs factored into the equation? Does this offer any sort of volatility play with derivatives of stocks about to undergo such a transaction?

6) Even though the discount has narrowed to around 20%, are emerging markets still cheap/attractive? Having been focused on 'value investing' for some time now (I have only recently branched out into options, hybrids, etc.) much of my portfolio shifted to foreign equities over the past year or so. But now I'm worried that such strategies have become too main stream.

7) Having read all the classics (Security Analysis, The Intelligent Investor, etc.) I now want to branch out. Are there any specific books on risk management or hedging instruments you might recommend?

Lastly, I'm interested in taking you up on your offer of a Minyanville subscription.

Anyway, any answer(s) at all - no matter how brief - are much appreciated.

Thanks a lot, and good job with the presentation!



Todd and I really enjoyed our talk at Harvard last night; there were excellent questions and I felt the beginnings of a new Minyanville community.

Hedge funds are, in theory, funds that are flexible, their trading strategies not restricted except by objective. They employ leverage to increase risk and employ various hedging strategies to reduce ancillary risk. In this way they attempt to isolate "spreads" that exist in various products in which they specialize. For example, a hedge fund might specialize in fundamental analysis in equities and build a long short portfolio of stocks (spread in fundamentals between companies) and use some leverage (although in this case I would not recommend leverage since that spread between stocks is risky by itself). Stat Arb hedge funds are also long and short stocks, but with a shorter time horizon and using technical analysis in making their decisions (these funds use more leverage as they are looking for smaller moves between more correlated stocks). There are hedge funds that trade spreads between bonds, some playing the yield curve and some playing credit spreads. These types of hedge funds tend to use even more leverage as the underlying assets typically have lower volatility than stocks, although that has not been the case in the last year (a very strange phenomenon). There are hedge funds like mine that trade spreads in derivatives; these types of funds are very mathematical in their approach and use moderate leverage. And now there are "hedge funds" that invest in long term private deals, but I don't really consider these hedge funds.

To correct a specific remark of yours, the term "equity-overwriting" is not really a hedge fund activity because that term suggests selling options one up against stock. There are funds that sell options systematically and use leverage, but these are not hedge funds because they do not hedge away ancillary risk (they assume heavy delta risk). There are hedge funds that periodically sell options, but only do so as an offset to long options (our fund will do this). In other words, they do not sell options systematically, but only opportunistically.

A hedge fund should concentrate on relative value between assets, on capturing spreads in value that exist as the vagaries of the market move asset prices around. In this way hedge funds actually add great liquidity to the market as long only funds have different objectives and time horizons. In fact, hedge funds have replaced broker dealers as the real provider of liquidity to the market (liquidity is a function of spreads). The amount of leverage a hedge fund uses should be negatively correlated to the risk in those spreads: the more volatile those spreads are (correlation risk between assets), the less leverage a hedge fund should use.

This is not always the case, however, which is why there are good hedge funds, bad hedge funds, and funds that call themselves hedge funds but are really not.

Your second question refers back to "equity-overwriting." As a stock rises, a fund, short calls, may not want to get called out of their long stock position (this could be for tax reasons, although I would not consider this a valid reason, for risk is more important). When they do this they change their risk profile and increase the risk of the stock going down. Rolling up may work for a while as the stock grinds higher, but the fund ever increases risk as they do it, leaving themselves open to losses that could wipe out several months of gains if the stock falls precipitously. There are far too many nuances to discuss as to how rolling up affects risk and how best to manage which options to resell. In general, though, when selling options one is making a bet that the stock will not be volatile; rolling up is in essence taking that bet off. In general I think it is a much better idea to just get called out of the position and re-enter if the stock goes back down to a price where the manager is comfortable in owning the stock. This ensures that the manager is sticking to the real strategy of selling volatility and not playing stock direction.

Your third question in reality is describing buying a put. The plus of buying a put is that there is limited loss if the market rises. The minus is that you only have a certain amount of time before your option become worthless, thus losing your entire "investment." In general, index options tend to be relatively expensive to individual equity options: hedgers always love their stocks, so they don't buy puts on them unless they have to, and hate the market, so they always defer to buying index puts (and paying up for them). Shorting a put is the exact same strategy as buying stock and selling a call, so when doing so one must be willing to own the stock at a price below the strike less the premium sold, and willing not to own it above the strike. Selling a naked put is a combination directional bet (accepting ownership at a price) and volatility play (the stock will not be that volatile).

Option pricing models in only a very indirect way incorporate small probabilities of large moves in stocks, whether it is caused by fundamentals or corporate activity. This is one reason why I said that individual equity options tend to be relatively cheap. Some corporate activity does create opportunity in option pricing (we have been involved in the Guidant (GDT)/Johnson & Johnson (JNJ)/Boston Scientific (BSX) saga) since the market is dealing often in binomial pricing and questionable timing of them.

You will never hear me comment on how cheap or expensive a market is: the primary driver of asset prices is sentiment or the risk premiums investors attach to them. Other variables like liquidity and the level of real interest rates affect that, but trying to predict the "psychology" of a market I believe is fruitless, so I leave that up to the salesmen of the world. You will hear me talk, however, about the macro situation and risk.

And lastly, I definitely would read "Fooled by Randomness." It has some good concepts, although like any book, be aware that any postulates about the markets are often naive.

We welcome your subscription to Minyanville. You will find many of your good questions have already been answered in more detail in the nearly 10,000 articles written by our professors.

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Positions in GDT, JNJ, BSX

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