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Contrarian Investment Strategy as PE Arbitrage

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Contrarian Investment Strategy as PE Arbitrage

By: Craig Mattoli

About the Author

An artist, liguist, physicist, arbitrageur who specializes in investment in inefficient, undiscovered, and misunderstood markets.

(ArticlesBase SC #845377)

Article Source: http://www.articlesbase.com/ – Contrarian Investment Strategy as PE Arbitrage

As a mathematical physicist and an actual arbitrageur (as opposed to armchair arbitrageur), I have a broader view of the arbitrage concept than many people. The original concept of arbitrage, its purest form, is simultaneous long buying and short selling of similar objects with no risk. For example, simultaneously, buy U.S. dollars with Euros, in London, and sell U.S. dollars for Euros, in Jakarta, for two slightly different prices to make a so-called spread, the difference between the prices in the two markets. Another type of currency arbitrage, which can be done in one market, is triangle arbitrage, using three currencies that are somehow out of alignment with one another.

As another example of arbitrage, we might conceive of buying convertible bonds and short selling the stock into which the bonds will convert. In that manner, you can create a virtually riskless position. It is a matter of looking at yield difference between the stock and the bond and creating an instantaneously riskless position. If you can earn a higher return than the riskless rate, you are ahead in the investment game. Moreover, because of the rules on securities holding for broker/dealers, you can also leverage such a position and put up only around 10 percent of the underlying long bond position, in this convertible arbitrage long-short position.

In merger arbitrage, there is risk: the risk that the merger will not go through. The arbitrage comes from an analogy for the special case of a share-for-share exchange merger. For example, XYZ Corporation might offer 2 shares for each share of ABC Corp., in a share exchange merger. That type of merger structure also has a tax advantage for shareholders, with the exchange not counting as a sale of shares. For the exchange ratio to be effective, the value of 2 XYZ shares must be greater than the price of ABC shares, trading in the market directly before the merger announcement. Then, if ABC’s shares had been trading at $30 before the announcement, and XYZ’s shares were trading at $25 per share, then, 2 shares of XYZ is $50. To set up a merger arbitrage position, in this case, the arbitrageur short sells 2 XYZ shares and buys 1 ABC share. In that manner, he locks in a definite spread, which will be earned, if the merger closes. Indeed, it does not matter if XYZ goes down after the position is taken on because ABC will follow. When the merger closes the arbitrageur will be given two shares of XYZ for every ABC share he owns, and the position, in his securities account will be short and long (called “short against the box”) and equal number of shares of XYZ.

In fact, the merger arbitrageur might also engage in capital gains tax arbitrage by “aging” his position and closing it out only after the gain has become long-term. Moreover, under capital requirements for broker-dealers, on a short against the box position, there is no capital requirement. Thus, the aging short against the box position is a zero investment riskless position with greater than a riskless return, at that point. As a result, a share exchange merger can become an arbitrage on top of an arbitrage.

We can look at brokers as doing a sort of riskless zero-capital arbitrage, in that they hook up a buy with a sell and get a riskless commission for so doing. Dealers and market makers are also engaging in a risky sort of arbitrage. They put up bids and offers on a security to earn the bid-ask spread, and, as long as they are able to trade flat every day, ending with no long or short position, they make the spread. There are arbitrages between commodities and their futures, as well as among stocks and their put and all options, and among the options. At the other end of the trading spectrum, a LBO firms are doing an arbitrage between the public market for corporate control and the private market for public control. A corporate raider is doing an arbitrage between a packaged public corporation and the private markets for its corporate parts. We recently did an article in buzzle.com that explained the Chinese export phenomenon as purchasing power arbitrage. We could go on with more examples and explanations of arbitrage, but we really should get to the point, so, we refer the reader, instead, to our website’s In Country Analysis page for further reading.

In the 1990′s, I took a dilapidated 18th century property, fixed it up, put my extensive collection of art and antiques in it, and turned it into an internationally recognized country inn. It was, in fact, just a double arbitrage. It took a collection of art and antiques and preformed private collection to public art viewing and retail markets arbitrage. I bought the art in the inter-dealer market, got an implicit rental for it, sold some at retail prices and sold the end of the collection with the property. I also did an arbitrage between mortgage payments on a residence and rental payments for overnight accommodations. Arbitrages are more numerous than people might first imagine.

The concept of Contrarian Investment Strategy was brought into the public awareness, in the late 1970′s by David Dreman. As any professional investor knows, one actually finds good investments in places where other people are not looking, either because of lack of general awareness, or lack of understanding. In that regard, the general mandate of contrarian investing is to invest, not willy nilly, in stocks of companies that are out of favor or that lack coverage by securities analysts, so that they are not in the public investment consciousness. In the end, those types of stocks are undervalued because of a lack of buying attention. That also means that they will have relatively low PE ratios, relative to other in-favor companies in their industry.

Normally, then, a contrarian investor does his own homework, mining these undervalued, low PE stocks and filtering out those that have low PE ratios, not because of any real financial problems, but because they have no investment following. The typical strategy, thereafter, involves going long the undervalued, low PE stocks. In so doing, the investor is, in another light, engaging in a sort of PE arbitrage, buying the low PE versus the industry standard PE, which he is implicitly, though not actually, short. This strategy has given wrought good investment returns, most of the time, but it is an unhedged, pure long strategy and, therefore, is still left open to the vagaries of the markets. That is a lesson that even the father of this strategy, David Dreman, has learned, this year. The idea that there is implicit protection lies in the fallacy that the stocks have already been beaten so low, that a down market should not hurt the naked long positions, too much.

A better way to implement this PE arbitrage, would be to also find those stocks, within the industries of the chosen long low PE stocks, with relatively high PE’s. Then, the contrarian PE arbitrage strategy would be to build a portfolio of long, low PE stocks and short an equal dollar value of high PE sticks, paired with the longs. In that manner, not only will the portfolio be a hedged portfolio but, also, to take full advantage of the PE arbitrage opportunity, earning a PE spread as both stocks, high and low PE pairs, gravitate to the norm. Moreover, even if the market goes up or the market goes down, the long-short pairs will counterbalance one another.

In the end, value investing is investing, not arbitrage. Value is defined in many ways, but it usually focuses on psychology. Another method that has been tried, involving this general psychological value focus, does take a two sided arbitrage approach, for example. A phenomenon observed by researchers [Victor Bernard & JacobThomas, "Post-Earnings Announcement Drift: Delayed Price Response or Risk Premium?" Journal of Accounting Research 27 (1989)] is called post earnings announcement drift. It has to do with a market inefficiency that information is not immediately correctly processed by real human beings. If the stock market is efficient, either expected earnings should already be reflected in stock prices, and an earnings surprise, one that is better or worse than the forecast expectation, should be rapidly assimilated into market prices. However, the reaction is actually stretched out for a whole fiscal quarter (60 trading days), in other words, until the next earnings announcement. There is some anticipation before the announcement, but abnormal returns continue even after the news has been announced. The phenomenon has been in the markets for decades. A strategy of going long a portfolio of the highest decile stocks with so-called standardized unexpected earnings, and short a portfolio of the lowest decile, those with bad earnings surprises, produced an average CAR, cumulative abnormal profits, of 4.2 percent over the sixty day period after announcement, or about 18% annualized. In addition, the effect is more pronounced for small firms, which are less covered by analysts and less followed by the investment community, resulting in a zero-investment strategy CAR of 5.3 percent, or over 21 percent annualized. Although the effect does last, on average, past the 60 day limit, it does seem to finally disappear by the end of a 180 day, or three quarter, period.

In the end, the only type of investment that will not be upset by an unexpected market crash is some sort of arbitrage strategy. We just use a broader definition of the term and the strategy.

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(ArticlesBase SC #845377)

Craig Mattoli -
About the Author:

An artist, liguist, physicist, arbitrageur who specializes in investment in inefficient, undiscovered, and misunderstood markets.

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arbitrage, investment strategy, contrarian investing, investment education

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Best Stock Option Strategies

As the markets have crashed in every possible way in the last month, everyone has got burnt. Stocks have crashed by 40% on average, which means that lots of people got hit by more than 40%. Stock portfolios, retirement funds, mortgages all look disastrous, and no-one wants to hear “buy and hold” anymore. Overall trust in investing and the stock market is at an all time low. Every investing strategy looks bad. Or does it?

Options trading is a strategy that is not dependent on the market direction, and in fact does better in volatile markets. That is what makes now the best time to trade options. So, why would you trade options?

Options trading does not need to be risky or a gamble. It is true that there are some people who do gamble with options, but they quickly lose their shirts and leave the field. Options trading gives you a wide range of strategies that have varieties of profit and risk potential. In fact, many strategies are significantly less risky than “buy-and-hold”, and most are significantly more profitable than just about any stock trading strategy that you can name.
When trading options, most of your portfolio is in cash for most of the time. In fact, even when you are actively trading, you can still have your whole portfolio in cash!
When trading options, your trades are by definition short term, and you do not need to hang around for months and months to see whether you make a profit or not.
Options work in ANY market – up, down, or stagnant. Best Stock Option Strategies

Which strategies are best to use during a recession?

Despite the massive leverage and profit potential of buying and selling calls and puts, it can look too much like gambling. In fact, if you don’t have a watertight strategy, it can be extremely risky. That is why it better to look at other possibilities.

Selling credit spreads. This strategy can bring in 15-20% profit on your portfolio per month, with no cash outlay, although you do need to put up margin. You can start with $1,000, and the only technical knowledge that you need is to be able to run a simple trend analysis. No trade lasts longer than a month, and you have an 80% or better chance of winning your trade.
Selling naked puts. You effectively get paid to buy your favorite stock, or in other words, you can buy stocks at greatly discounted prices. Or you can treat them like credit spreads, and run trades every month in an upwardly trending market.
Selling covered calls. If you own a stock, you can sell a covered call on it every month. In a downward trending market, this helps you recoup your losses. In a stagnant market, it helps you reduce the net cost of your stock. In an upward trending market, you can lock in your profits on a stock and move on.

These are all very low risk strategies, that can easily bring in a monthly income of at least 10-15% on your portfolio. You will not need to be glued to a computer screen day after day, and all three of these strategies can be accomplished with less than one hour per month in front of your computer. Each of these strategies takes advantage of time decay, the concept by which options lose value very quickly as their expiration date approaches.

There are other strategies such as Iron Condors, Straddles, Strangles and so on, which can be very effective, but none are as reliable nor as safe as these other three. In addition, they often incur higher brokerage fees.

Strategies such as DITM (Deep-in-the-Money) options trading can be useful if you favor a swing trading type stock strategy. You effectively buy stocks at about half price. Buying and selling calls and puts is hugely profitable, but highly risky. Both of these strategies are very susceptible to the effect of time decay. Best Stock Option Strategies

Day Trading Software Reviews  >> Using a Trading Strategy or a Stock Market System ? How to Make Money Picking Stocks

BY.- http://www.StressFreeTraders.com

Beginner traders often fantasize or wonder

about how some people are able to achieve tremendous profits by trading stocks just a few hours on a daily or weekly basis.

So going beyond the hype

& the bells and whistles that a lot of the called “trading gurus” like to invoke, the real “secrets” of the stock market game are enclosed within the trading set ups and market signals you rely on to decide how to CHOOSE stocks, as well as WHEN to BUY & when to SELL them, or even when to SHORT SELL those that are poised for a profitable fall.

So the clearer your set ups are, the faster you can spot a potentially profitable trading scenario and ACT ON IT reducing your risk.

Complicated technical systems and information overload can make you slow and confuse you right from the start, making you loose money instead of making your profits grow.

In essence, You can be sure that the trading method you employ to approach the stock market and pick stocks can make a big difference in your results as a trader. In order to succeed you will need to FOCUS on a set of simple trading strategies that you can implement without hesitation.

Fortunately some sites on the web do offer more effective and updated day trading methodologies. One of those sites that can show you how to take advantage of certain stocks on positive and negative momentum as well is http://www.StressFreeTraders.com

They focus on momentum stock trading strategies, that are practical and easier to apply than many other technical systems out there.

Stock trading doesn’t have to be complicated as many people perceive. But you do need to follow a well organized set of rules and tactics, that once you master them, you can aspire to replicate profitable trades with consistency.

Here is a list of some financial vocabulary with very easy to interpret definitions. This list will include investing, common accounting and business terms. Hopefully this glossary will be really helpful for the aspiring entrepreneurs, students and those who entering in the business and who have never ever had a dignified business education. Purchasing a stock that means you own a part of an organization.

A stock is the lowest share that is accomplishable. A stock is brought out by the companies who bring up capital to deal a small portion of their company. Those people who hold the stock as well hold the suitable voice beliefs about how a company endures and share the profits. Even though stock proprietors have some rights, they do not confront responsibility if the company faces a cause or defaults. The worst thing that can happen to a capitalist is that their Stock will contain no value and they will suffer their investment.

If you are interested in the option stock trading, then you should be concerned in option stock trading schemes. To understand Stock options in a better way let’s see an easy dictionary definition. Strategy can be outlined as a skill in planning or managing, especially by using ploys. The words planning or managing using stratagems to accomplish a specific end or objective is rather useful in our hope to employ this definition to the investing market. Investing in the Stock Market is actually not something that all of you know about and for the common man it might look like a chilling place where people can release a lot of money.

Assuring the market break down in several places affrights a lot of people and discourages them from enduring into investing in the stock market. Even so, the stock market is not inevitably a place where you release money, on the opposite; you can gain a lot of profit if you can discover your way more or less the market. The stock market can be confusing and complicated for all experience levels.

Those people who are just getting their despoil into the stock market can discover it to be intense. In contrast, Full-fledged traders can still frequently become mixed up by a turn of events. The stock market is the market which is ever-unsteady and oftentimes misinterpreted. Novices as well as the highly experienced can be very well assisted by the free stock quotes that can help conduct the way through the market. The term Stock Market is really a very immense subject that addresses the bond market, trading, portfolios, stock market and even stock term jargon or slang. So, if you are curious about what precisely this article contains, let me give you an overview. This article named primarily comprises all the terms relevant to stock, from the entire categories world wide of stock market finance, and as well includes the jargon and Phrases that you would most know specifically, if you are entering in the stock markets.

Product Description
This student-centred book provides a set of financial tools and techniques for gaining access to and evaluating a company’s corporate and business strategy. It helps students to research information on a company, develop a generic Frameworks for analysing a company’s business environment and the industry in which it operates. Students learn how to combine financial and non-financial information in order to come up with a balanced overall assessment of a company’s st… More >>

Corporate Strategy and Financial Analysis: Managerial, Accounting and Stock Market Perspectives

Margin of Safety is one of the most popular value investing strategies made popular by stock market legends like Benjamin Graham (father of value investing) and Warren Buffet. Margin of safety is simply a value stock investing model where the investor assigns a margin of safety to his/her value assessments.

In value investing, the investor estimates (or predicts) the intrinsic value of a stock. The concept is that every stock has an intrinsic value and price changes from this intrinsic value is just deviations resulting from the actions of market forces. The stock will often return to its intrinsic value when the market forces weaken. Thus investors who buy stocks when the trading price is below the intrinsic value and investors who sell stocks when the trading price is above the intrinsic value will profit.

But what make value investing difficult is predicting the intrinsic value of stock. There are no established rules for finding out this. Investors should develop their own strategies and models for this purpose, according to availability of information and analysis tools he has. Many traders use different indicators like book value, open offer, P/E ratio, asset to liability ratio, institutional investments, investments in other companies, etc to finding the intrinsic value of the stock.

Margin of safety investing strategy easily overcome this difficulty of predicting the intrinsic value. Investors assign a safety margin as percent of predicted intrinsic value (usually is 30 to 40 percent of intrinsic value). Margin of safety investors only buy stocks when they are trading below margin of safety. In this way he/she can minimize the risk/error of predicting the intrinsic value. The more the percentage of margin of safety the lower the chance of risk, and the better the chance of profit.

For example is the predicted intrinsic value of a stock is $10 and margin of safety is 30%, then the trader only buys the stock if the current trading price is below $7 ($10 – 30% of $10). If the actual intrinsic value is only $9, and the stock returns to this level, the investor will have a profit worth $2.

The main advantage of margin of safety investing strategy is that it offers a margin rather than a fixed price to reduce risk. It favors all type of investors, both experienced and novice investors, and does not necessitates any position sizing or market performance requirements. But the disadvantages are that it does not present any rules for assigning margin of safety and does not consider market factors. Also there is chance of substantial loss when margin of safety is less and scarcity of opportunities when margin of safety is high.