Special Situations Trade – Deutsche Bank

A few years ago my family was thinking about buying a Smart, these super-trendy cars that were in everyone´s mind. Suddenly I saw Smart cars everywhere in the city. I once heard that this tendency of humans to focus on things recently learned about is based on the activity of our reticular activation system basically helping us to focus on things of “importance”, but I am not a biologist. The same thing has happened to me recently and is connected to the Deutsche Bank trade idea that I indicated in the last post. Unfortunately, I was a little pre-euphoric about this idea (as so many times in my posts). But here is my idea.

Do you remember Jack D. Schwager´s book “Hedge Fund Market Wizards”? I wrote an entry about it and mention it quite frequently! Anyway, I love the book and have been listening to the audio book 24/7 for the last few weeks. The lessons of two managers especially captivated me. These men are Joel Greenblatt and Jamie Mai. The former is the author of “The Little Book That Beats The Market” which I recently wrote about (I am still analyzing the performance of the magical formula – there are some issues with the data though). The latter hedge fund manager has been loosely portrayed in Michael Lewis´ book and the movie “The Big Short”. He made a killing during the financial crisis buying Credit Default Swaps on mortgage backed securities, multiplying his capital 80 times .

What connects these hugely successful hedge fund managers is their emphasis on bets expressing limited risk with unlimited return potential, so called skewed bets. Fundamentally, buying options offers this potential. Generally, options are found to be overpriced in the market and as many as 90% expire worthless out of the money. However, both  Greenblatt and Mai spotted situations in which options can be of great use. These are “special situations”. A special situation occurs when the stock performance depends on an uncertain outcome.This could be due to  a lawsuit, regulatory action, or a pending acquisition. In this case the market is uncertain about the future development of stock. What we can almost certainly assume however (which the market does not do), is that at the point  in the future when the uncertainty is resolved the shares will not trade at the current level. They will either trade much higher or much lower, corresponding to the result of the special situation.

Option pricing formulas contrary generally assume a normal distribution when a multimodal distribution seems more appropriate (see the difference below).This  leads to possible large price inefficiencies of options in these kinds of situations. Thus buying a call option of a company that currently is target of an acquisition might express a skewed bets. As Mai puts it the market generally over discounts the share price in special situation related to possibly negative results.

normal_distribution

Let´s relate this now to the Deutsche Bank case. Since the disclosure of negotiations with the U.S. Department of Justice and possible fines of up to 11 billion Dollars the stock lost much of value and I thought to have found one of these special situations. According to U.S. Authorities´ decisions either Deutsche Bank shares would recover or crash.

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Since its low in mid September however, the stock has already regained its losses and it is hard to evaluate the upside of a possible trade and whether the skewed bet still exists at this time. It was an interesting idea, but I was a little slow.

Best,

Nils

Plans vs. Reality

Trading seems so easy. As a human you spot patterns everywhere, so you do in the markets. You watch the markets, you fantasize about applying your strategy, you paper-trade a little bit and your approach seems incredibly profitable. So, you finally start trading your approach and nothing is the as you expected it to be. You loose and loose and loose and then you loose some more. You think the statistical probability of this should be miniscule but… you keep on loosing. Trade after trade, every trade until you feel emotionally drained.

This is what has happened to me in the last two months in which I lost around 13% of my trading capital. During this time I lost money on literally 100% of my trades – supporting the notion that human nature tends to lead to worse than random performance in the markets. I would spot a great trading strategy with superior win/loss percentage and upon entering, the position would instantly go against me, forcing me to exit the trade. It indeed, was very fascinating how I seemed to make exactly the wrong decision in virtually every situation. This experience made me aware of quite a few things.

Firstly, in the anticipation to finally start trading I had evaluated my trading strategies in a completely overconfident way. I assumed both favorable executions and perfect exits and entries. However, I oversaw completely the effect that high volatility can have on the human psyche.

Secondly, research has shown that most people are risk-averse. We feel more pain when we loose money than we obtain pleasure when win the same amount. When, as a day trader, you sit several hours a day in front of the screen watching your position go up and down (especially down), this very (very!) fast drains you emotionally. After the market opened and I watched my position I would feel like 2 hours had passed just to see that we were just 10 minutes into the session. After being stopped out of my position mostly after 1-2 hours (6pm European time) I would not just be completely exhausted from the “session” but my losses would actually seriously impact me emotionally. More than once after having turned off the computer I felt almost depressed being confronted with the difference between expectations and actual results. The more I traded and the more I lost the guiltier I felt for having lost money in the markets despite “knowing it better”.

What kind of conclusions should I take out of this emotional impact on me? Honestly, I do not know yet. Loosing is a part of the game of the financial markets and I guess that you have to get used to it if you want to have success. However, in any case I should be more careful about which trades to enter instead of running after every opportunity that presents itself. Since I am still looking for the optimal trading strategy that fits my personality maybe in a few months I will conclude that day trading is just not for me and that instead I should use a longer time approach (the magic formula for example). I really do not know but at the moment I still am fairly confident about the system that I want to trade.

The third thing that I observed in the last two months refers actually to a positive observation. My stops usually were pretty good. Not only did I exit my positions after my stops had been hit, but the stops seemed of good quality as well. When they were reached they always clearly indicated that my trade had been invalidated. Thus, I did not feel any additional urge to re-enter the position.

So, that is what I have been up to trading during the last two months. Let´s see how the future turns out. Next week I will hopefully be able to provide a statistical analysis of the magical formula and write about a trade idea regarding Deutsche Bank.

Best,

Nils

 

The Magic Formula

 

the-little-book-that-beats-the-market

Joenl Greenblatt has found the magic formula for stock investing. That´s what he claims and indeed he seems to know one or two things about the stock market. He was portrayed in Jack. D. Schwager´s “Hedge Fund Market Wizards” in which he was assured to have achieved incredible yearly returns for his fund. So, he seems to be reliable. Greenblatt claims that applying the magic formula offers  returns twice the general market returns.

Indeed, the magical formula is quite simple, very simple actually. Greenblatt advises people to buy good businesses for little money. He spots these business based on two criteria:

  1. Return on capital: For this the following ratio is calculated (Earnings Before Interest And Taxes) / (Net Working Capital + Net Fixed Assets). EBIT is used since different companies are subject to different tax rates which should not affect the return ranking though. Net Working Capital + Net Fixed Assets are included in order to incorporate the capital needed in order to run the company´s business.
  2. Earnings yield: For this (Earnings Before Interest And Taxes)/(Enterprise Value) is applied instead of a normal P/E ratio since the enterprise value includes possible debt effects.

He does not look for companies with a good position in one of these two but he looks for the companies with the best combination of these characteristics. In order to achieve this he constructs rankings of the 3500 largest American companies based on return on capital and earnings yield. The rankings are then merged representing the companies with the best overall quality. Then, he advises to invest in the 30 “best” companies, which offers both for quality and diversification. After one year before process should be repeated. That is all already. Seems too easy to be true, right?

So, if it is that easy, why does he tell us about it? If it is so easy why doesn´t everyone follow this process? His answer to this question is BELIEF. Greenblatt says that you need to belief in the formula to make it work. This sounds very “New Age” like but it actually makes a lot of sense. Value investing does not work every day. The magic formula does not outperform the market in every year, at times it underperforms the market for two consecutive years or even more. And this is the reason why it will never become a mainstream investment style. After the first year of underperforming the market many investors will quit the strategy and look for more profitable investment strategies. Since most people lack the discipline to stick to their methods Greenblatt is not afraid of loosing his edge by writing a book about his magic formula.

Greenblatt is convinced that the magic formula functions since while in the short run the market can be incredibly inefficient it tends to converge to efficiency in the long run. Beneath I have listed the 30 best rated stocks according to the magic formula in 10/07. Make a judgment yourself.

Best,

Nils

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One-Period Binomial Model

Since I could not keep up with the pace covered in class I have to jump to a little more advanced topic today. However, this will introduce how market completeness and contingent claims can help in pricing and introduces a famous relation: The Put-Call Parity.

For this purpose our model assumes t=0,1 and two scenarios (w1,w2). We assume there to be a risk-free security, a risky security and a call-option. The prices of the risky security at t=1 in scenario w1 and w2 are uS (up) and dS(down) respectively. u and d are considered to be returns. We can show that

u > 1+ r > d

is the condition for a complete and arbitrage-free market. The payoffs for the call option are max(uS-E,0) and max(dS-E,0) respectively where E is the strike price of the risky security. Thus the minimum payoff generated by the option is 0 and the option will be exercised if the price is above the exercise price. This is the initial, complete and arbitrage-free market.

To this initial market a put-option is introduced and since the market is arbitrage free and complete the payoff if this option can be replicated by a strategy δ in the risk-free and risky security and the call option. Thus:

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The matrix has rank two which is less than the number of unknowns. Thus we have one degree of freedom and infinite solutions. Indeed, the payoff of the put option can be replicated. Actually we can show mathematically that

p = c – S1(0) +E/(1+r)

The price of the put is equal to the price of the call minus the risky asset at t= 0 plus the present value of the strike price invested in the risk-free security. This is the famous Put-Call Parity.

With this the one-period model ends and the multi-period model begins.

Best,

Nils