Lecture 4: Equity Strategies

Daniel Macauley

Lecture Outline

Passive Trading Strategies

Enhanced Indexing
Pairs trades
Futures
Options
CFDs
Shorting
Quantitative Trading Strategies John OBrien

Passive Trading Strategies

Make as few portfolio changes to minimise
costs
Buy and hold
Not really a strategy

Indexing
Strong Rationale
Costs are a drag for average investor
Efficient Market Hypothesis
Removes Principle Agent problem

Auction Trading Strategies

Order that is worked during the day may be
completed in the Auction, if this is large enough
an imbalance may occur.
Opportunity to take the far side of this.
Tracking Funds / ETFs often make use of the
closing auction if an index is being reshuffled.
Eg MSCI / FTSE / STOXX 50 etc
Studies have shown that some indices have
been degraded by up to 2% because of the
above.

CRH entering the Stoxx 50

Index addition trade

September 09
CRH to enter the Stoxx 50
Main European index
Large amount of stock to be purchased by index
funds
Estimated to be 35mn shares to be bought on the day
of entry
Equated to 15x NDV
Stock ran strongly into entry date and subsequently
fell away.
Sell and shorted an equal number of CRH shares.

CRH Index addition graph

Tate & Lyle into the FTSE 100

Ashmore into the FTSE 100

CRH Continued

CRH Why did it not work?

Index addition but not just passive
acquirers
Market was strong
Santa Claus rally
Irish Companies relisting

Enhanced Indexing Strategies

Exclusion rules
Use of filters, eg exclude excessive debt

Trading / Execution enhancements

Algorithmic execution to try to add value by efficient
trading

Portfolio Construction
Scrip Arbitrage
Enhanced Cash
Futures Arbitrage

Scrip Dividend Arb CRH

HOLDERS HAVE THE OPTION TO REINVEST THEIR CASH DIVIDEND OF
EUR0.485 IN NEW SHARES AT PRICE
OF EUR13.83 PER NEW SHARE.
Decision Date: Friday 17th of April 2009 @ 3pm

Compare the Scrip price to current price

Doesnt Work with DRIPs

SCRIP Arb CRH

SDA Part 2

This can be important to CFD providers.

Pay the cash div on the ex date to clients
Hedged with long position in the stock
Wait until last minute to decide cash or
SCRIP
Can lock in the profit by short selling the
no. of shares to be received
Might do partial

Following the Money /

Stakebuilding
Warren Buffet
Denis OBrien
Independent News & Media

ICG
Dermot Desmond
Barlo
Irish Banks

Watch for 30%

Tesco

Tesco relative12 months

Directors Dealings / Insider

trading
One of the most profitable trading
anomalies.
Good track record over last 50 years.
Works well internationally not just in the
US.
Not just a market cap effect.
That is works with large caps.

Directors Dealing
Not just directors

Largest shareholders
Legal advisors underwriters and consultants

Not allowed to trade on material non public info,

but
Regulators find it difficult to know if individuals are
acting on non public info.
Easy close to the event but what about the several
months leading up to a significant event?
Agrawal et al (2010) dealing reduces six months
before a takeover.
Sales fell much more than purchases.

Directors dealings
Long History evidence in the 60s in the US.
First big study in the 70s looked at buying the stocks
directors bought and sell those they sold no effect
even after screening for size.
However intensity 3 buyers or sellors gave abnormal
returns of just under 5%.
Seyhun et al in the 80s 6.5% outperformance using
intensity but also,
CEO, CFO, large shareholders most important .
Transaction size larger more important.
Returns were primarily driven by purchases not sales.

Is this partly a convention? Enron / Irish Banks, etc

US 1978 05

Issues
Lack of consistency
Number of years when it doesnt work
Especially 96 to 98

Has worked well recently, especially first

half of the decade.
Also just in terms of the return profile over
half of the excess returns are generated in
the first two weeks.

Issues contd.
Higher returns in small cap.
Average returns using intensity is almost 1%
higher.
Works very well in the last 10 years to 2007.
Not informational on the sell side?
Sales under Rule 10b5-1 statistically negative return.
Cooper et al (08) companies with serious earnings
mis-statements have much larger director selling.
End of a significant run of earnings beats.
Lack of sales for home purchasers very strong returns
liu et al (07)

Short selling strategy

Zacks 2011
As before not statistically significant returns if
strategy is implemented without screening.
Screening

Intensive
Eliminate small transactions
Limits the sector - BM , ind, UT, etc
Large caps

The above strategy will generate abnormal returns

rel to S&P 500 of c. 7% per annum over long period
20+ years.

Directors dealings Sectoral factors

More information asymmetry in certain
sectors.
Less in others.
Difference of 1% a month between highest
and lowest.

Is it used

Very little research for institutions.

But probably yes.
Lot of focus on acquiring / providing the information
One or two good examples eg Gotham Capital

Individuals
Yes but trading publications info was / is very lagged and as a result
negatively impacted returns.

Internationally
Germany Dymke et al (07) one month differential of c. 6%
Netherlands Biesta et al (03) purchases 9% over 6 months, sales -7%
over 6 months.
Etc, etc
Spain 30 day lag doesnt really work.

Market prediction
In aggregate that is sales less purchases
Net purchase ratio NPR
Shows,

Lowest NPR most sales

Directors are contrarian
Sell after large up moves
Lowest 20% of NPRs 12 month market return of 7%
Highest 20% of NPRs of 21%

Basis for a market timing indicator?

Recent Developments
SOX in 02
Before 10 to 40 days, no real issue with late filings.
Before this there were issues with implementing these
strategies.

SOX 2 days to file, done electronically on SEC

website.

Much easier to implement strategies

2010 study Brochet et al
Before SOX three day return was 0.6%
Now?
This is the 3 day after filing get 1% from transaction date.

Directors Dealings Buys

Directors Dealings Sells

Insider trading

Illegal in developed markets

Serious issue in emerging markets
Leaky markets
However not illegal if information is
inferred
Mosaic theory
Means something different in the US

Leaky Markets
Placing / open offers
Go with the flow more likely you are wrong
Alternatively might have missed
something

Gamesa

Trading Strategies Rights

Issues
Nil Paids
Leverage
Stamp

If you are a holder you should be a sellor on the

day or so of the rights announcement
Can be significant stock in the market place so
can get a decent bounce at the end.

CRH RI

CRH RI

Greencore Rights Issue

Cineworld Rights Issue

Cineworld Rights Issue

Cine Nil Paids

Trading Premia and Discounts to

NAV
NAV Net Asset Value
Only relevant in Closed end funds (Investment Trusts)

These investments can trade at Premia or Discounts to

NAV
Listed Fund of Hedge Funds
e.g. Dexion

Investment Trusts
e.g. Alliance Trust

NAV also used as a valuation metric

Property companies
Oil Exploration Cos

Trading Premia and Discounts to

NAV - Dexion

Trading Premia and Discounts to

NAV BB Biotech

Premia to NAV Activist Investor

Discounts to NAV Hansa

Bubbles & Crashes

Can provide excellent trading opportunities
When prices rise substantially above
fundamental value.

1929
1987 (Reaction)
NASDAQ
SUB PRIME
Quiet periods - mini crash 89

Where will the next one be? What will it involve?

Arbitrage
Opportunity occurs when correlated prices
diverge
Profit from price convergence
Hedge portfolio costs of carry
Residual risk
Basis for L-S equity

Arbitrage 2
Pure eg Oil NY & London (in the past)
S&P Futures & Cash arbitrage
Index Enhanced ETFs
buy cash when futures are expensive and vice
versa

Speculative / Risk Arbs

Long short

Brent and WTI

ADR Arbitrage Strategies

ADRs
Denominated in USD

There is an arbitrage between the

underlying and the ADR.
Strategy for investment banks who have
very low transaction costs opportunities
very small
Exceptions Ryanair, Allieds

M&A Arbitrage
When one company makes an offer for
another
Usual is to buy the target and sell the
bidder.
Eg Cadbury / Kraft
Buy Cadbury
Higher offer

Arbitrage continued
Number of risks implementation, basis, Model, carry,
slow convergence, short squeeze
In reality done in stages to minimise
Use market orders if spread is small
If one side is illiquid do it first
Both sides interleave orders
Basis risk risk that arb basis will move in the opposite
direction most important, hard to mitigate, size if key, if
BR is low use leverage, forced liquidations happen at the
worst time. Must not be fully levered LTCM
Model risk is that the change in basis is not a arb
opportunity.

Pairs trading

Simplest long one stock short another.

Or long the stock short the market.
Can be beta adjusted.
Often employs leverage
Can be closely correlated or not
depending on the risk profile of the fund.

Long Short
Identify winners / losers using fundamental
analysis
Purchase / sell risk adjusted amounts to
remove market risk.
Using more of the information long only
one side.
Also can be correct in long only but will
still lose money if the market falls.

Long short II
Market neutral
No directionality
Use of Leverage

Directional
Less Leverage?
Higher risk?
Correlation with equities {long bias}

Long Short Trade BP

Long Short Trade BP

Long Short Trade BP

Long Short Trade BP

Long Telefonica short Deut Tele

RYA / EZY

Irish banks????

Statistical Arbitrage
This involves using factor models to
generalise the pairs trading concept to
many instruments.
Stat Arb select the instruments and the
quantities to trade in order to control risk
whilst maximising profit.
Transaction cost consideration is key
Numeric optimisation to fine tune
decisions.

Placing Strategies
Larger Blocks of shares placed on the markets.
Either,
New shares such as Tullow.
Existing shareholding such as the 29.5% stake in ICG
sold on behalf of Liam Carroll.

Usually done at a discount to the market price.

Price often weak in the run-up to placing as top
shareholders are given notice.
Also price weak on the day of the placing.

ICG share price

Glanbia Placings @ 7.60

Brewin Placing

Equity Futures
A futures contract on a stock market index
represents the right and obligation to buy or sell
a portfolio of stocks which comprise the index.
Not just Index Futures also Single Stock
Futures.
Margin Initial & Variation
Leverage
Exchange traded
Settlement - cash settled

Equity Index Futures

Cash settled
No delivery of the underlying stocks.
Contracts are marked to market daily.
On the last trading day, the futures price is set equal
to the spot index level and there is a final mark to
market cash flow.

Leverage
Initial margin on the S&P 500 Index is about 5%.

Equity Index Futures

Dollar value is the futures price by a
multiple
E.g. S&P multiple is $250
So if index level is 1,000 contact is
$250,000
What happens to the margin account of an
individual that is short 10 contracts and
the index falls from 1150 to 1140?

Futures Pricing

Basis for futures pricing is arbitrage

Cash and carry trade
Reverse C&C trades
Theoretical price
Cash price + cash price * (financing cost yield)

Bounds
Financing, transaction costs, etc

Equity Futures Trading strategies

Uses

Easy to short an index or a market sector

Long an entire index cost effectively
Basis for some ETFs
Changing the Beta of a portfolio
Hedging for cash flows in a fund
Withdrawals
Contribution

Cross Hedging
- Mismatch risk

Changing Portfolio Beta

Portfolio managers adjust their portfolio betas as they
perceive risk and return changes.
When they are bullish, i.e., they believe that the stock
market offers a relatively high expected return for a given
level of risk, they will increase the beta of their stock
portfolio.
When they are bearish, (or think that the risk of the
market has increased), they will decrease their portfolio's
beta.

Changing Portfolio Beta

N=

- P
F

Portfolio Value

(Futures Price) Multiplier

A negative no. is a shot position in the futures

Changing Portfolio Beta

A fund manager believes that the stock market will
decline in the next few days.
However she does not wish to incur costs (coms,
spreads etc) of selling stocks and then repurchasing
them after the decline that he anticipates.
Solution: The manager uses futures contracts to hedge
the portfolio against the expected market decline.

Changing Portfolio Beta

A PM owns a portfolio of $20 million in stocks with a portfolio
beta of 1.2.
Suppose, the S&P 500 index level is 1275 and the observed
futures price is 1280. What is the risk-minimizing position?

Set the target portfolio beta, d, equal to 0. Using the

equation, the PM manager should sell 75 futures contracts.
Suppose the manager was right about the market's
movement, and the S&P 500 declines to 1224, which is a
4% decline in the market.

Changing Portfolio Beta

If beta was estimated accurately, the value of the managers
equity portfolio should decline by 4.8% (1.20 times 4%). This
results in a loss in the capital value of the portfolio of $960,000.
Now assume that the futures price also declines by 4%, to
1228.80.
A futures price decline of 51.2 points results in a profit of
$12,800 on one futures contract. On a position of 75 short
futures contracts, the profit would be $960,000.
Here, the hedge eliminated the effects of the market decline.

Indexing Strategy using futures

Indexing using stocks expensive
Tracking error
Solution
Replicate the index using index futures and tbills
Buy the futures and invest the cash in t-bills

Enhanced Indexing Arb strategy

Purchase of futures when they are cheap.
Converse purchase stock when futures
are expensive compared to theoretical
value.
This would be done using a program
trade.
Aggressive strategy would involve
switching back and forth.

FTSE 100 futures

10 per point so 5,400 equal 54,000

Typical margin 3%
30:1 gearing
Cash settled
Third Friday of delivery month
Quarterly cycle
As with most futures front month most
liquid

Index Future Arb Strategies

FTSE trading at 5300

50 days to expiry
Rates are 5%
Financing cost is
5,300 * 50/365 * 5% = 36 index points
But expecting dividends worth 10 index points
Fair value = 5300 + 36 10 = 5,326

So with the cash index at 5,300 would expect the future to be 5,326
If it strays from here then arb
There is a channel for the spreads, financing costs and assumptions
around dividends.

Risks to Index Arb strategies

Suspension of s Stock in an index
Long stock basket, short index future
If a stock is suspended and replaced in an index then
the future price doesnt change but the underlying
stock basket will

Cash Flow
Short a large futures position
Rising market need to post substantial variation
margin.
This leads to substantial cash outflows and although
you are hedged receive no cash flows from hedge

Equity Option Strategies

Equity Options
Options on stocks and indices, both broad
and narrow.
OTC vs exchange traded
Calls, Puts
Premium
Strike price
Expiration leaps

Covered Call Strategy

Option is the right to buy or sell.

Call option is the right to buy.
Short a call, collect premium.
Purchaser has the right to call stock
Enhanced income strategy.

Covered Call Strategy

Strategy for a fund / portfolio of stocks.

Overlay strategy to enhance income.
Sell \ Write calls.
Typically on a portion of the holdings on a rolling basis.
e.g. 3 month calls and write one third every month.
Target premia not distance from strike. (vol)
Obviously do not write calls on stocks with potential CA.
Often combined with Protective Put Strategy.

Works well except in major Bull Markets.

Contracts For Difference

Agreement to exchange at the close of the
contract the difference between the opening
price and the closing price of the contract
multiplied by the amount purchased or sold
Primary vehicle for Hedge Fund & Prop trading
Advantages
No stamp, no income tax?
Shorting is easy
leverage

Contracts for Difference

Not the same as owning the stock
Available for pretty much all stocks but
margin varies
5% for Tsco, 50% for UTV
Two offerings
Synthetic DMA
Quote Driven

Never be fully leveraged.

CFDs
Like shares commissions are charged on
purchases and sales negotiable
e.g. purchase of 5000 CRH
CFD provider buys the 5,000 CRH
Cost is 100,000
In a long position the CFD provides the financing
spread over EURIBOR on the position.
Margin is posted usually c. 10%
Receive(negligible) interest on portion of cash
not used for margin.

CFDs

Converse for Sales

Sell the 5,000 CRH short
CFD Provider sells the CRH
Investor recieves interest on the short position
Usually Libor / Euribor less a financing spread

Pays the dividends

CFD funding vs stamp duty

CFDs & Dividends

Received as cash flows on the ex date for a long

Paid away on the short on the same date
Tax differential
Immediacy around dividend

No voting rights
Depends on hedging for implementation of
interests!

CFD Strategies
Ease of leverage contrast this with a
futures, options
Shorting stocks Indices
Used for hedging of positions
Currency hedged trading
Pair trading enablers

Shorting
Intention to sell a share with the intention to
repurchase at a lower price.
Some restrictions banks in Ireland
Must borrow the stock to short, unless using
CFDs (provider arranges)
Different skill set from long only.
A key issue is that a short that goes wrong
grows in size, converse is true is a long position.
Also losses can be theoretically unlimited.

Short squeeze