Wednesday, October 6, 2010

The Lunatics are Running the Asylum

Just came across this trade put on by the hedge fund Pershing Square during the height of the BP panic this summer: short equity puts and long CDSs.

If you recall, this is almost the opposite of the trade I had recommended in, when I recommended buying bonds and shorting equity.  While selling volatility during a panic is a legit strategy, they were absolutely on the wrong side of the trade as far as the capital structure arb goes.  Pershing took enormous tail risk had the stock dropped further to near bankruptcy or bankruptcy-in-fact levels w/o a credit event bringing value to the CDSs, which was  a very real threat.  In constrast, if Pershing was trying to pick bottoms in a panic, the more appropriate strategy would have been to just buy bonds or short CDSs.  My suggestion to short equity in addition to buying bonds would have brought about profit in every circumstance, allowing it to be levered to the hilt, especially considering how much size you could take in the bonds and equity of such a high-volume large cap.  If you noticed, bonds have rebounded pretty much completely (nearly 100% gain), while the stock has bounced back only 15-35%, depending on where you would have managed to close out the capital structure arb.

Wow, and I'm the guy trading my own peanuts worth of cash to scrape by in the markets?  I'll take the Yalies' money any day.