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Hedge Fund Arbitrage Strategy Exposed

Posted on March 22, 2009 by Adam

This is the first post in a series of articles that will uncover some of the proprietary trading systems used by succesful hedge funds across the world.

Some hedge funds adhere to a buy and hold strategy, which works fine in a bull market, when everything is going up. Jim Cramer is a prime example of that. However, you can bet that buy-and hold hedge fund managers are on the rocks these days. Bloomberg recently ran an article that covers how the too-posh-for-you hedge fund haven of Greenwich Connecticut has become a ghost town over the last year, evidence to the carnage among those who thought stocks could go up forever.

But it’s not all bad in the hedge fund industry. Some funds will make it through this mess. How? These hedge funds have adhered to intelligent risk management, and clever proprietary trading systems. These are trading systems they don’t want you to know about! However, with enough knowhow, it is possible to figure out how they do it, and reproduce it. That’s where I come in.

I’m here to help you make money. In this article, I will explain one proprietary trading system that big hedge funds use to make loads of money, no matter what. But, shhh, don’t tell anyone!

Don’t be fooled. This strategy involves being very nimble and quick. I know for a fact that big funds use proprietary computer algorithms to find these setups and trade them automatically. In addition, this strategy requires a lot of capital to execute properly. Without being substantially capitalized, commissions will eat into any profits you make.

This strategy is an options arbitrage strategy that capitalizes on violations of put call discrepancy. It sounds extremely complex, but it is actually quite simple. If you have a basic knowledge of options theory, you should be able to follow it. If you need to brush up, I’ve written an article on introductory options theory that should get you up to speed.

Put call parity is essentially the principle that a long call should have the same risk profile as a trade involving a long stock position in combination with a long put. To make it even more simple, it means that puts and calls of the same strike price should have equal time value.

Let’s look at a real example involving Apple Computers, (AAPL: 258.11 -1.09%). Here is a link to the option chain showing front month options. Looking at the 100’s, we can see that the calls are trading at 6.15 (the ask price) and the puts are trading at 4.65 (also the ask). Apple is currently trading at 101.59. The puts are out of the money and have no intrinsic value. The calls have an intrinsic value of 1.59, leaving a time value of 4.56. The puts have a time value of 4.65, which is the entire premium.

In theory, these two values should be equal. Since they are not, an opportunity for arbitrage exists. There is a 4 cent discrepancy, which can be turned into risk-free profit. Here is how.

In this situation, a hedge fund would sell puts, let’s say 100 contracts, for a total cost of 4.60*100*100 = $46,000 (you must sell at the bid price). The fund would simultaneously buy an equal number of calls, for a total cost of $61,500. Finally, the hedge fund would short enough shares at the market price to cover the 100 contracts. Since each contract controls 100 shares, 100*100 shares would have to be sold, for a total cost of $1,015,900. That brings the total margin requirement of the trade to $1,123,400.

At expiration, one option will expire worthless, and the other one will be trading at pure intrinsic value.

Let’s say AAPL is trading at 110 at expiration. The puts are out of the money, and worthless. The entire premium sold would become profit. $46,000 would have been made. The calls will have increased in value. At expiration, their intrinsic value will be $10. Since the fund was long those calls, it will have made money on those too - a total of $61,500 - $100,000 = -$38,500. However, the shares sold would have increased in value, offsetting most of the gains. The shares will be worth $1,100,000, or $84,100 more than they were sold for.

Total profit = $46,000 + $38,500 - $84,100 = $400

It doesn’t matter which way the stock moves. The profit is locked in as soon as the trade is taken.

It may seem like a small gain, but it is completely risk free. On top of that, commissions would cut a large chunk into that profit.

The real options arbitrage opportunities arise when bigger price discrepancies arise. It also helps when the options are cheaper, typically in low-volatility scenarios. Occasionally you will see options trading with as much as 25-50 cents discrepancy in their extrinsic values. Those options make for the best arbitrage.

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