Two things must be kept in mind when establishing a long position in this kind of hedge. First, since Treasury bond futures contractsrepresent face value of $100,000 worth of Treasury bonds, the investor will want to go long approximately $100,000 worth of closed-end bondfunds. When it comes to trading closed-end bond funds, I do not recommend buying more than 2000 or 3000 shares of a single fund for a short-term trade. That is why we would go long several different closed-end funds, representing positions of from $31,000 to $34,000 and amounting to approximately $100,000. That $100,000 long position offset the short position of 1 September U.S. Treasury bond futures contract at 100.18, priced at a 7.943 yield.

On February 10, 1978, with the Dow Jones Bond Average down to 89.79, two significant changes had taken place since we established our theoretical long and short positions: (1) The long positions in the bond funds had become profitable, and (2) so had the short position in the Treasury bond futures contract. For example, JHS was selling at 175/8, up from 167A; DBF was up to 165/8 from 161/2; and PAI had gone from 135/8 to 1334. The net asset values of all three funds had declined but the discounts, as predicted, narrowed more than the decline in net asset values, resulting in the profits.

FundsThe proceeds from the sale of the long positions on February 10 would have been $101,287.50, resulting in a gain of $1550. Covering the short position in the Treasury bond futures contract would have been at 96.12,resulting in a profit of $5187.50 and a total gain on the long and short transactions of $6737.50.

The type of hedge just described is primarily directed to the institutional investor. At the same time, it is designed to demonstrate to all investorssome of the key advantages obtainable in trading bond funds as opposed to dealing strictly in straight corporate bonds.

4. Buy a closed-end fund that is going to be open-ended or liquidated and that is selling at a discount; sell short the stocks in the fund’s portfolio. This is an almost riskless arbitrage. As the closed-end fund approaches the date that it is to become an open-end fund, the discount will narrow. As an open-end fund it will not sell at any discount (redeemable at NAV). The trader is locking in the amount of the discount as a profit, with the shortseliminating risks of changing market prices that might occur before the fund is open-ended.

For example, Schafer Value Trust announced plans to liquidate in April 1990. If you would have purchased the fund shortly after that news, you would have paid $10 per share, which represented a 5-percent discount from its net asset value. At the same time you could have sold short the five largest positions of the fund at the prices indicated in Table 10.2. The fund paid liquidating distributions totalling $10.675, of which 96 percent was paid within three months, representing a gain of 6.75 percent, while the short positions created a loss of 2.96 percent. This is an overall gain of 3.79 percent, with much of the risk eliminated from thetransaction.

5. Buy an equity closed-end fund at an excessive discount; sell naked call options against the fund’s portfolio positions. If the stock market declines, the diminishing time factor of the option, plus the probable erosion of the price of the underlying stock, exerts pressure on the excessive premiums of the options. This probably would result in a greater gain on the short option positions than the resulting loss in the long position in the excessively discounted closed-end fund. If the market rises, in-the-money options will tend to lose their rich premiums and will probably not rise as fast as their underlying stocks. In addition, the diminishing time factor is working against the option. At the same time that the underlying stocks rise, the net asset value of the fund should increase, combined with the probable narrowing of its discount possibly causing it to become more profitable than the loss developing in the options. The hedge may also be benefited by dividends being received on the long positions in thefund.

For example, in June 1977, U.S. & Foreign Securities (UFO) was selling at an excessive discount of 26.7 percent. Its net asset value was 20.97, and the fund was selling at 153/8. The Dow Jones Industrial Average was at 912. A purchase of 4100 shares of UFO at 155/8 would have cost$63,375.

Had one of each of the following naked calls been sold on the major positions of UFO, the proceeds from the sale would have been $3718.75: IBM October 260s, selling at 61/4, Amerada-Hess November 30s at 51/4, Digital Equipment October 40s at 41/2, American Telephone & TelegraphOctober 60s at 4, General Electric October 55s at 2, Texaco October 25s at 21/16, Corning Glassworks December 30s at 1 7/8.

By September 24, 1977, the discount on UFO had narrowed to 20.7 percent. The price of the stock had risen to 10, in spite of a down market (the Dow Jones was at 839). Yet UFO’s net asset value, after rising in August and September, was exactly where it had been in June-20.97. At that juncture the hedge could have been closed.

Proceeds from the sale of 4100 UFO shares at 16 5/8would have amounted to $68,162.50, the cost to cover the short positions in the calls would have been $2622.25. This would have meant a gain from the long position of $4787.50 and on the short position of $1096.50, for a total gain of $5844.

6. Sell short a closed-end fund selling at a premium; write naked put options against the fund’s portfolio positions. This is effectively the reverse of hedging method, that is, taking advantage of the fund’s excessive premium rather than an excessive discount.

Possibly related posts: (automatically generated)
Continuous Full Investment with Hedging continue…