One thing we have focused on heavily in the last month is presenting strategies used to create absolute returns – that is, manage risk and turn trading profits regardless of the general market’s direction. It’s a difficult market, and the days where simply owning a handful of hot tech or commodity stocks could result in good returns is gone. What are you going to do about it?
The solution I’ll offer is to show some humility. The market is volatile, and it’s easy to lose money quickly if you don’t manage risk. This is why stockpicking now is about relative value, unless you have a very long time frame and don’t mind seeing potentially large paper losses in the interim. At the heart of a relative value strategy is trading pairs long and short against each other. Trading long/short is about identifying the relatively overpriced and underpriced securities and taking the appropriate action, eventually taking profits when the pricing discrepancy narrows. Long/short is at the heart of many absolute return strategies, because it can help manage the risk of a sharp market move.
For over a month, we’ve been suspicious as to the sustainability of market rallies led by financials. But outright shorting (or buying puts on) financials is a risky strategy; the SPDR Financial Sector ETF (ticker: XLF) rallied over 40% in a very short time. That could have meant serious losses for getting in at the wrong time. One way to play financials while managing risk that was suggested here involves a long/short play on capital structure. Specifically, convertible arbitrage using Bank of America convertible stock was analyzed. Although we concluded that the specific security was not underpriced, turning this trade into a long/short play by owning the convertible and shorting the number of common shares one has a call option on (20) has proved a superior strategy to owning either outright.
Important to note above is that simply owning the convertible security would have outperformed simply owning the common essentially all the time. How do the numbers work?
The convertible stock (ticker: BAC-L) is down 23%, and the common (ticker: BAC) is down 48%. Keep in mind, all of this has occurred over about one month. Even if volatility indices (like the VIX) are down off their highs, there is still substantial volatility in the marketplace. So, using the numbers from Friday’s close:
Shorting 20 shares of BAC common stock = 13.90 * 20 = +278
Covering 20 shares of BAC common stock = 7.18 * 20 = -143.6
Profit/Loss on Short = 278 – 143.6 = +134.4
Buying 1 share BAC-L convertible preferred = -647
Selling 1 share BAC-L convertible preferred = +486
Profit/Loss on Long = -647 + 486 = -161
Net Profit/Loss = -26.6
Net P/L as % = -2.88%
S&P 500 % Change = -4.17%
Over the last month, this trade has lost a slight amount of money (ed. note: it would have been in the green using Friday’s open prices), although some small battle can be claimed as won by outperforming the S&P with less risk. Where to on this trade from here?
There is incremental value added to the convertible preferred because of the limitations placed on Bank of America’s dividend policy; per the government, common stockholders are entitled to no more than 1 cent per share per quarter in dividend payments. No such change was dictated to the convertible preferred, so there is now a large income spread between the two securities. Further, with government policy showing little regard for shareholders (as it should) and more senior securities trading at large discounts, the best way to gain exposure to financials will continue to involve managing risk through relative value bets. Remember that value can be added both through earning excess profits, as well as eliminating losses, and trade accordingly.