Practical Considerations and Risks - Portfolio Trading, Index Arbitrage, and Dispersion Trading
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1 Practical Considerations and Risks - Portfolio Trading, Index Arbitrage, and Dispersion Trading Ron Chiong Associate Director Risk & Strategy CEO s Office Securities and Futures Commission October 2014
2 The views expressed in the following material are the author s and do not necessarily represent the views of the Global Association of Risk Professionals (GARP), its Membership or its Management. 2
3 Agenda Portfolio Trading (cash equity agency trading) Index Arbitrage (cash equity principal trading) Dispersion Trading (equity derivatives market making) Global Association of Risk Professionals. All rights reserved.
4 Agenda This is NOT a SFC presentation This is NOT a mathematics class Please raise questions anytime Global Association of Risk Professionals. All rights reserved.
5 Portfolio Trading Agency Business Portfolio Trading Programing Trading Agency Execution Who / What are involved Human (internal / external dealers; facilitation traders) Robot (computer programs; algorithmic trading) Access (FIXs and DMAs) Venue (Exchange, crossing engine, dark pool, OTC) Global Association of Risk Professionals. All rights reserved.
6 Portfolio Trading Excellent training for junior trader Regulation Trading mechanism Market infrastructure Expectation from clients / sales / bosses Friendship with FO, MO, and BO (plus controllers and compliance) Multitasking (cross markets and multiple clients) Global Association of Risk Professionals. All rights reserved.
7 Portfolio Trading Business Portfolio sales do all the client facing work Portfolio traders Orders are in the system correctly (Excel, Bloomberg, FIX, phone call, etc) Follow client s instruction Timely communication nobody likes surprises Seamless post trading reporting and settlement Regulatory compliance (execution, booking, allocation, restriction list) Global Association of Risk Professionals. All rights reserved.
8 Portfolio Trading Risks System failure (always have third party backup) Algo (know your tool; kill switch) Booking error (wrong allocation, wrong investor account) Human error from manual operation Settlement (unsuccessful DVP; wrong client position) Global Association of Risk Professionals. All rights reserved.
9 Portfolio Trading Advice Everybody makes mistakes report early and ask for help! Best execution to client you are doing agency business! Comply and Respect execution policy and regulation don t play in grey area! Global Association of Risk Professionals. All rights reserved.
10 Index Arbitrage Using component stocks to reconstruct an index Index arbitrage = Long/Short position in stocks + Short/Long positon in index futures Business Principal trading Source of inventory for stock lending Global Association of Risk Professionals. All rights reserved.
11 Index Arbitrage Index arbitrage => difference between the values of 1) stock index* 2) futures implied stock index* *(1) is built according to the methodology provided by the index service provider *(2) is the stock index value implied by the futures contract Trading Buy stock basket and sell futures when (2) - (1) - costs* >0 Sell stock basket and buy futures when (1) - (2) - costs* > 0 * Costs = internal/external brokerage fees, ticket fee, stamp, levy, etc Global Association of Risk Professionals. All rights reserved.
12 Index Arbitrage Stock basket construction Same size as futures position Hang Seng futures price = 25,000; multiplier x HKD 50 Basket size = HKD 1,250,000 per 1 futures contract Global Association of Risk Professionals. All rights reserved.
13 Index Arbitrage # Contract Price Amount (HKD) HSI Oct 14 Futures 1 25,000 1,250,000 Code Stock Index Weight Price # Shares 5 HK HSBC 13.73% , HK Tencent 8.61% HK China Mobile 7.53% HK AIA 6.29% , HK CCB 6.08% ,816 etc (total 50 stocks) Global Association of Risk Professionals. All rights reserved.
14 Index Arbitrage Futures implied stock index Futures = [Index PV(Dividend)] x e r(t-t) Dividend => stock component dividends r => funding rate T-t => residual life of futures contract Solve for Index Global Association of Risk Professionals. All rights reserved.
15 Index Arbitrage Risks (set-up) Do not rely on a single data source Build your own index to avoid delay Present all parameters clearly on screen Try to move away from spreadsheet Know the latest technology (The Need for Speed!) Clear compliance on restriction list Test your trading system for speed and accuracy Make sure your finger is not FAT! Global Association of Risk Professionals. All rights reserved.
16 Index Arbitrage Risks (execution / operation) Wrong dividend assumption wrong futures implied stock index Fail to update database suspension / split / merge / change code / lot size / weight in index, etc.) Fail to understand the funding status of the platform Make sure you secure your funding for your position Robotic behavior blindly follow the green light Bid-offer spread what the green light showing against? Liquidity of small stocks in index Global Association of Risk Professionals. All rights reserved.
17 Index Arbitrage Risks (execution / operation) Fail to understand the logic of index arbitrage Long stocks short futures -> cash outflow for margin when market goes up Short stocks long futures -> chance to have your stock loan recalled when market goes down Futures rollover Avoid last minute rollover Triple check all rollovers are done on expiry day Future position limit issue Unwind; swap to forward or ETF (at fair price) Do not shock the market when you do the unwinding No market manipulation Do not shock the market when you do index name change No market manipulation Global Association of Risk Professionals. All rights reserved.
18 Dispersion Trading Using options on the component stocks to reconstruct an index option Also known as Correlation Trading and Volatility Arbitrage Dispersion trading = Long position in stock options + Short positon in index options Global Association of Risk Professionals. All rights reserved.
19 Dispersion Trading Business Backbone strategy for option market makers Option inventory warehouse Facilitation of client activities Global Association of Risk Professionals. All rights reserved.
20 Dispersion Trading Dispersion = > spreading out Correlation = > going together Dispersion = α i σ i2 - σ I 2 α i = weight of component stock i in index I σ i = volatility of component stock i in index I σ I = volatility of index I Global Association of Risk Professionals. All rights reserved.
21 Dispersion Trading Stock Weight Volatility Weight x Volatility Square A 16% 20.0% B 22% 24.0% C 18% 27.0% D 25% 30.0% E 19% 23.0% Total 100% Index 100% 20.0% Dispersion Dispersion Index Volatility 17.5% Dispersion Index Volatility 20.0% Dispersion Index Volatility 22.5% Global Association of Risk Professionals. All rights reserved.
22 Dispersion Trading Operation Buy optionality of each stock component Sell optionality of the index In theory you trade gamma until expiry of all options In real life you trade delta, gamma, and vega Options in the book are unlikely to expire at the same time Options in the book are unlikely to be stable due to change in volatility, spot, time, and client activities Global Association of Risk Professionals. All rights reserved.
23 Dispersion Trading Good day All stocks move in different directions (dispersed movement) Index does not move Bad day Index moves Stock components with under-weighed gamma move Stock components with over-weighed gamma do not move Global Association of Risk Professionals. All rights reserved.
24 Dispersion Trading Risks Tracking error from imperfect portfolio Bad positions from client activities clients may skew / screw your book Non-model base trading trader s discretion; suggestion from boss Slippage in hedging execution issues, unavailability of stock borrow Global Association of Risk Professionals. All rights reserved.
25 Dispersion Trading Risks Unstable option positions from expiry Unstable gamma positons due to changes in spot Unstable gamma positions from near the strike expiry Unstable delta, gamma and vega positons due to remarking of volatility curve Other issues (Mis-match in volatility smile, implied delta, etc) Global Association of Risk Professionals. All rights reserved.
26 Q&A Global Association of Risk Professionals. All rights reserved.
27 Thank You Ron Chiong Associate Director Risk & Strategy CEO s Office Securities and Futures Commission rslchiong@sfc.hk hk.linkedin.com/in/ronchiong/ Global Association of Risk Professionals. All rights reserved.
28 C r e a t i n g a c u l t u r e o f r i s k a w a r e n e s s Global Association of Risk Professionals 111 Town Square Place 14th Floor Jersey City, New Jersey U.S.A nd Floor Bengal Wing 9A Devonshire Square London, EC2M 4YN U.K (0) About GARP The Global Association of Risk Professionals (GARP) is a not-for-profit global membership organization dedicated to preparing professionals and organizations to make better informed risk decisions. Membership represents over 150,000 risk management practitioners and researchers from banks, investment management firms, government agencies, academic institutions, and corporations from more than 195 countries and territories. GARP administers the Financial Risk Manager (FRM ) and the Energy Risk Professional (ERP ) Exams; certifications recognized by risk professionals worldwide. GARP also helps advance the role of risk management via comprehensive professional education and training for professionals of all levels Global Association of Risk Professionals. All rights reserved.
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