Hedge Fund Methodologies - How To Price Spreads And Baskets

Introduction

Hedge funds are always in the media, and frequently regarded as secretive and esoteric.

This is largely due to a a lack of detailed specific information regarding what hedge funds actually do. To help combat this, I have decided to write a short series of articles describing how long/short equity strategies may be defined.

Long/short equity hedge funds generally go long certain shares. And short others. Some may maintain a market neutral position. This means that for every million pounds of stock that they hold, they'll short a million pounds of another stock. Others may have a long bias. For example, maintaining a 70% long, 30% short portfolio.

The portfolio selection processes can be discretionary or systematic. In this opening article, I shall describe the basic pricing process, and move on to technical selection processes at a later date.

Pricing Products

In order to compare stocks, the prices need to be normalised to enable a like for like comparison. For example, if stock XYZ goes up by 10% and stock ABC goes up by 10%, then we'd probably want a market neutral spread between the two to remain static.

This is commonly done by dividing prices by a "base price", where the base price is normally a recent historical price of the associated stock.

For example, if XYZ closed at 232 last night, we could set the base price to be 232. Assume XYZ opens at 250 the next morning. The rebased price would be 250/232 = 1.07759.

It is clear that this represents an overnight increase of 7.759%.

Now assume that ABC has moved from 450 to 459. Using 450 as the base price, the new rebased price would be 1.02.

The spread between XYZ and ABC is therefore:

1.07759 - 1.02 = 0.05759

ie. The spread has moved 5%.

So a trader who'd been long the spread over night, holding a market neutral position, would have made a 5% return on the nominal value of his position.

This concept can be expanded to baskets of shares. For example, if a trader wanted to trade a market neutral position of XYZ against a 50/50 weighted basket of ABC and DEF, the rebased spread would be:

n(XYZ) - 0.5 * n(ABC) - 0.5 * n(DEF)

where

n(X) = (Price of X) / (Base price of X)

In essense, these simple pricing methodologies are used to define new synthetic tradable products. Unlike normal shares, they do not follow lognormal random walks, and do not have an upwards drift. However, some traders and hedge fund managers believe that they possess inefficiencies that can be exploited.

Some of these inefficiencies will be investigated in later articles.

Jon C is an Internet Entrepreneur and Trader. If you have any questions regarding this article, please contact him via the comments for on

http://www.dawjee.com

Reuters - Evidence of a weakening economy and further global efforts to avert recession dominate financial markets this week, so much so that the U.S. presidential election on Tuesday is almost taking a back seat.

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Stock Market Trading - 4 Proven Ways You Can Make a Profit in an Economic Slowdown

In these day of the credit crunch and all the economic slowdown in general, is there still a way we can make any money from the plunging stock markets? Yes there is, it is even possible for us to make more in markets that are heading South, in unbridled free fall, than if they head up.

What we do is short sell, and this is done either through you broker, your bank, or an online account. I prefer the latter by using spread betting. When we open a Sell position, we are in effect borrowing a stock to sell at its current price. The stock we choose is determined by our thorough research criteria. Our prediction is that over a period this stock will go down in value. Assuming the price goes down, then we reverse our position later on and buy it back, at of course, the new lower price. The difference in the value is our profit.

Here are 5 ways you can use this technique:

Using Day Trading, we open a position, which is usually founded on using technical indicators, and it remains open for a duration of anywhere from a few hours to a few days. Trading with a management facilities, our stop loss system will protect us from losing too much if thing the trade goes against us, in this case, up.

Swing Trading is similar to day trading and employs the same indicator types. It is focuses on taking advantage of price swings in trending markets. Positions are usually held for a longer period, up to say three weeks.

Range Trading. If you notice a stock whose price seems to generally fluctuate in a well-defined channel between two parallel lines, then this is called a range. The line underneath is usually called support, and the upper one, resistance. Just like a zig-zag across you chart really. It will be horizontal, or sloping in either down trend, or up trend. The trick is to take advantage of, in our case the price as it bounces off the resistance line, or breaks through the support line.

Scalping is taking advantage of volatile markets. This strategy is fast paced and scalpers don't spend more than minutes or seconds in markets that lend themselves to this method. A big advantage is the minimal exposure of your cash to the market, thanks to the tight spreads.

The Foreign exchange or Forex, is immensely popular, trading currency pairs such as the US Dollar with the UK Pound or the Swiss Franc with the US Dollar. Many traders make a living on trading just one currency pair. Scalping is a good way to trade the Forex because it is usually highly liquid in nature.

So as you can see, there is enormous scope for making the most from falling markets.

How would you like to discover more about the techniques successful traders use to make profitable trades?

Download them free here: Day Trading Course

Ian Jackson is an authority on Day Trading information, learning the hard way - and now he reveals how you can learn the business too, without all the growing pains.

Reuters - Stocks climbed on Thursday as investors snapped up shares trading near their lowest levels in five years on optimism that aggressive rate cuts by global central banks, including the Federal Reserve, will help cushion a worldwide economic downturn.

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