Hedge Funds Trading Strategy

8/14/2019 Hedge Funds Trading Strategy

1/9

MSF 547: Hedge Funds

Stuart School of Business

Keywords: Discretionary spread trades, event based strategies, trade analysis

Long-Short ETF

Trading Strategy

Spread Trade- Long: GEX

(NYSE) and Short: NLR

(AMEX), XES (AMEX)

Rohan Patil


2/9

Abstract

The trading strategy discussed hereafter attempts to exploit the impact of the current environmental,

political and technical trends on the spread between Market Vectors-Global Alternative Energy ETF

(NYSE: GEX), the SPDR Oil & Gas Equipment & Services ETF (AMEX: XES) and the Market Vectors-Nuclear

Energy ETF (AMEX: NLR).

We shall start our analysis with the fundamentals of this strategy wherein various geopolitical aspects

will be discussed. This is followed by the technical analysis of the market prices. The penultimate section

of this paper discusses the exit strategy and risk management aspect of the trade. In order to hedge thetrade two hedging instruments have been selected which will be discussed. This is followed by the

money management aspect of the trade.

I am grateful to John Showel, Geneva Trading LLC and Prof. Russell Wojcik, IIT for their guidance.
http://www.nyse.com/http://www.nyse.com/http://www.nyse.com/http://www.amex.com/http://www.amex.com/http://www.amex.com/http://www.amex.com/http://www.amex.com/http://www.amex.com/http://www.amex.com/http://www.amex.com/http://www.nyse.com/


3/9

1. Fundamental Analysis :

(a) Economic, political and environmental aspect:

The issue of Global warming has been at the forefront of political and economic debates for more than a

decade. Additionally, we have experienced a huge increase in the price of crude oil in the last couple of

years. These two factors have compelled the economy to look for alternative solutions to fulfill the

energy requirements.

In the recent past, certain energy projects in U.S. involving the use of conventional sources (i.e. coal)

have been blocked citing environmental reasons. [1] Also, a large proportion of corn produced in U.S. is

now being used to make ethanol. Several such examples can be cited to indicate a paradigm shift in the

energy policies inclining towards alternative energies.

This issue is being widely discussed in the political arena especially the presidential campaigns in 2008.

After all other candidates had grown out of the competition we are left with two candidates with an

entirely different approach towards the energy independence.

Democratic candidate, Sen. Obama, has championed alternative sources of energy whereas the GOPcandidate, Sen. McCain, has been emphasizing on drilling more oil and on the use nuclear energy. Based

on the current events and opinions, it is clear that the Sen. Obama has a better probability of becoming

the next president.*** 1

This peculiar environmental, political and economic situation leads me to be bullish on the Alternative

Energy ETF and at the same time to be bearish on the Nuclear and Oil & Natural Gas exploration ETFs.

1 ***A detailed description about their energy policies can be found here:http://en.wikipedia.org/wiki/Comparison_of_United_States_presidential_candidates,_2008
http://en.wikipedia.org/wiki/Comparison_of_United_States_presidential_candidates,_2008http://en.wikipedia.org/wiki/Comparison_of_United_States_presidential_candidates,_2008http://en.wikipedia.org/wiki/Comparison_of_United_States_presidential_candidates,_2008


4/9

(b) Selection of ETFs:

1. Market Vectors-Global Alternative Energy ETF (NYSE: GEX) [2]

Replicates the performance of the Ardour Global Index (Extra Liquid) (AGIXL)

Globally traded stocks of 30 alternative energy resources, distributed generation, energy

efficiency, enabling technology and environmental technology companies

2. SPDR Oil & Gas Equipment & Services ETF (AMEX: XES) [3]

Seeks investment results that correspond to S&P Oil & Gas Equipment & Services Industry Index

Invested in 25 companies in the business of drilling oil-wells & making supplementary products

3. Market Vectors Nuclear Energy ETF (AMEX: NLR) [4]

I believe these two ETFs track the alternative energy, the oil equipment & services and nuclear energy

with sufficient accuracy. [5]

The trade involves three ETFs, alternative energy, nuclear energy and oil & gas equipment & services

respectively. These will be referred to using their ticker symbols hereafter.
http://www.nyse.com/http://www.nyse.com/http://www.nyse.com/http://www.amex.com/http://www.amex.com/http://www.amex.com/http://www.amex.com/http://www.amex.com/http://www.amex.com/http://www.amex.com/http://www.amex.com/http://www.nyse.com/


5/9

2. Trading Analysis:

Long position involves GEX and the short position involves NLR and XES. Now we have to decide how

many shares of NLR and XES should be sold for every share of GEX bought. Constraints of beta neutrality

and dollar neutrality are put on to find out the exact position on the short side.

i. Beta Neutrality:

CAPM beta is used to measure the market risk. Thus, we need to match the betas of the long and short

side to be market neutral. *

* Here the risk free rate was 3.45 %( annual; Source: Bloomberg)

ii. Dollar Neutrality:

The average price of these instruments over last one month is used to make the trade dollar neutral.

Note that we are using this constraint to estimate the ratio of the short side and not to be precisely

cash neutral.

Avg Price

XES 33.989

NLR 23.220

GEX 41.212

*Average price was calculated from 9/5/08 to 10/06/08

Equations to find the ratio are as follows:

1.036* x + 1.005* y = 1.275

23.22* x + 33.989* y = 41.212

Solving these two equations, we get;

x = 0.161, y = 1.103

CAPM Beta

XES 1.005

NLR 1.036

GEX 1.275


6/9

Thus, for every share of GEX bought we shall sell 0.161 shares of NLR and 1.103 shares of XES.

Price Graph:

Spread Graph:

The spread has increased significantly from a low of -$12.44 on July 2 nd into the positive territory. In my

opinion, this trend will continue throughout the time horizon of this trade.

Long GEX and Short NLR & XES

$25

$30

$35

$40

$45

$50

$55

$60

$65

3/3 3/17 3/31 4/14 4/28 5/12 5/26 6/9 6/23 7/7 7/21 8/4 8/18 9/1 9/15 9/29

Date

P r i c e

Long Short

Spread

-$14

-$12

-$10

-$8

-$6

-$4

-$2

$0

$2

$4

3/3 3/17 3/31 4/14 4/28 5/12 5/26 6/9 6/23 7/7 7/21 8/4 8/18 9/1 9/15 9/29

Date

P r i c e


7/9

3. Risk management:

a. Exit Strategy:

A 5% stop-loss strategy should be followed for this trade given the high level of volatility in the markets.

b. Hedging the exposure to oil and political uncertainty:

The SPDR Oil & Gas Equipment & Services ETF (XES) has historically shown a high correlation with the oil

prices. The correlation calculated here is based on the data of last 6 months. In order to hedge this risk,

we will have to go long oil futures (CLA) for the month of December 2008.

The correlation with Oil is as follows:

CORREL NLR XES GEX

OIL 0.445 0.623 0.376

Based on our ratios and these correlations we should buy 0.38 contracts of oil futures for every 1000

spreads.

Apart from the exposure to oil, this trade is also exposed to the political uncertainty which can behedged by buying options on the candidate which adversely affects the trade. In our case we need to

buy binary options on Sen. McCain. These options are traded publicly and have enough liquidity. [6]

The current rate of this option is $31.1 for a payoff of $100 at the maturity and one contract is of 100

options.

Now, selecting the number of contracts to buy depends on our exit strategy. We shall exit this strategy

whenever 5% loss occurs. That means we need to buy enough contracts to offset this loss. Given the

returns on this option, we need to buy 0.025 option contracts for every 100 spreads we buy.


8/9

4. Money Management:

1. Spread: At the current market price (i.e. closing price on Oct.6 th 2008) the price of one spread is

about $0.075473. Thus, in order to buy 1000 spreads we need $75.47.

2. Rebate and borrowing cost for the short leg: Also, we need to calculate the borrowing cost for

the ETF. The rate of borrowing, in all likelihood, is firm-specific. In the calculations presented

here I have assumed a rate of 30 bps annual.

For 1000 spreads, we need to short 1000*(0.161*17.09+1.103*23.9) i.e. $ 29113.19 worth of

ETFs.

Now, assuming that the rebate is fed funds rate minus the borrowing cost, total cash-inflow for

borrowing the ETFs for 72 days is 72* (0.0345-0.003)/360*29113.19 = $ 183.41.

3. Margin Payment: To buy the crude oil futures we need to pay up a margin of $12,488 per

contract. For 1000 spreads it is 0.38 * 12488 = $4,745.44.

4. Commissions: Additionally an 8 bps commission cost is going to be incurred which can be

calculated as $ 58300* 0.008*2 = $93.28.

Thus, to execute 1000 spreads we need about $4730 , out of which only -$15 is the inflow when we

execute the order. Rest of it is the upfront margin payment to hedge with crude oil futures.


9/9

References:

1. STEPHEN POWER (2008) Kansan Stokes Energy Squabble with Coal Ruling Official Cites Warming In

Blocking Two Plants; 'Ground Zero' in Fight , Retrieved: October 5, 2008, from CHESAPEAKE CLIMATE

ACTION NETWORK, Website: http://www.chesapeakeclimate.org/news/news_detail.cfm?id=523

2. Market Vectors Global Alternative Energy ETF Trust, Retrieved: October 5, 2008, from New York Stock

Exchange, Website: http://www.nyse.com/about/listed/gex.html

3. SPDR Oil & Gas Equipment & Services ETF, Retrieved: October 5, 2008, from American Stock

Exchange, Website: http://www.amex.com

4. Market Vectors Nuclear Energy ETF, Retrieved: October 5, 2008, from American Stock Exchange,

Website: http://www.amex.com

5. Roger Nusbaum, New Oil Subsector ETFs Prove Refined, and Retrieved: October 5, 2008, from the

Street, Website: http://www.thestreet.com/etf/etf/10295399.html

6. Visit for contract details: http:/www.intrade.com/

More information: http://predictions.wsj.com/

7. Francois-Serge Lhabitant, (2006) Handbook of Hedge Funds, Hoboken, NJ, Wiley Finance
http://www.nyse.com/about/listed/gex.htmlhttp://www.nyse.com/about/listed/gex.html

Hedge Funds Trading Strategy

Documents

Transcript of Hedge Funds Trading Strategy