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Using Relative Value for Arbitrage

 
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arthur
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PostPosted: Sun Oct 03, 2004 10:46 am    Post subject: Using Relative Value for Arbitrage Reply with quote

Jul was an excellent trading month for me, although the stock market was down, since I made big gains on calls, e.g. SNDK EK AMGN KLAC SOHU AU SIL etc., and puts, e.g. OEX QQQ DIA and OIH. However, Aug and Sep were brutal trading months. The semis fell further than I expected, and my portfolio fell from $935,000 in late Jul to $790,000 in Sep, which was my worst trading period in years.

However, I noticed, the Dow led Nasdaq lower in Aug and Sep. Also, the semis failed to lead Nasdaq higher. Consequently, I expected the Dow to lead Nasdaq higher, and semis, which were severely oversold, would follow Nasdaq. Therefore, I bought DIA (Dow index) calls first. When DIA rallied, I sold the calls and bought SMH (Semi index) calls, which lagged the rally. When SMH rallied, I sold the calls and bought INTC calls, which lagged SMH. INTC rallied and I hedged the INTC calls with QQQ puts, since QQQ rallied sharply.

Also, FDX was overextended before earnings. So, I bought FDX puts to hedge my calls. FDX fell sharply on earnings and I sold the puts for big gains. AMGN fell sharply and bought calls, which also hedged the FDX puts. When AMGN rallied sharply, I sold the calls. I bought OIH (oil index) puts, since OIH was also overextended. Eventually, I bought SLB calls (an oil stock) to hedge the OIH puts. When SLB rallied sharply, I sold the calls and bought NEM (gold) calls, since NEM was down, to hedge the OIH puts, since OIH was way up.

Consequently, my portfolio rose from $790,000 to $860,000 within a month. My gains would have been much more, except I made two critical mistakes trading OIH and EBAY puts. Nonetheless, by taking advantage of relative value for arbitrage opportunities, I recovered much from my recent poor performance. Moreover, what's less obvious, I recovered much of the losses while managing risk (e.g. using both calls and puts on the right stocks at the right time and at the same time to hedge).

Now in early Oct, I suspect the semis are in position to rally further, while I expect volatility to pick-up. Therefore, I plan to buy calls on semi stocks on dips and hedge those calls with QQQ puts, which are relatively overvalued. If volatility picks-up, I may eventually make gains on both calls and puts, while managing risk.
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