From Theory to Practice

The Short Side: Stocks & Bonds

| Jun 20, 2016
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    From Theory to Practice

    The Short Side: Stocks & Bonds

    Jun 20, 2016

    Since the start of From Theory to Practice, we’ve peppered the idea of short stocks and/or short bonds into a number of the segments, but to date, we’ve not done a piece that addresses this combination in conjunction with one another. Therefore, in this segment we propose that given both mathematical principles and current market conditions, it makes a lot of sense to consider trading both the stock market and the bond market from the short side, simultaneously.

    The case for short stocks can be made by a number of mathematical reasons. The negative skew (huge outlier moves tend to occur on the way down, rather than the way up) and positive kurtosis (more outlier moves occur than we anticipate) both suggest strong support for shorting stocks. Furthermore, carrying short delta in our portfolios offers a natural hedge against our short premium. This is because being short premium equates to being short volatility, and thus we are hurt if volatility were to expand. However, an expansion in volatility would normally be accompanied by a drop in prices, so our short delta would help to shield these losses. In addition, my dissertation showed a price impact asymmetry in the market place that could help to explain the velocity we typically observe during market selloffs.

    Support for short bonds can also be justified quantitatively. Given where we are with an instrument like /ZB on the price-yield curve, and the convexity of that relationship, an increase in interest rates could elicit a dramatic fall in bond prices. Furthermore, with interest rates still hovering around zero, it would be tough to argue that we aren’t in a rising interest rate environment. No one knows when interest rates will rise exactly, but they will most certainly rise over the coming years.

    The inverse relationship between stocks and bonds gives your portfolio a tremendous amount of ‘strategic diversification’, if they are paired together. If we are scalping these instruments, and we apply the concept of managing winners, then it is very likely that one of these two will always be in play and yield an opportunity to take off at a profit.

    This video and its content are provided solely by tastylive, Inc. (“tastylive”) and are for informational and educational purposes only. tastylive was previously known as tastytrade, Inc. (“tastytrade”). This video and its content were created prior to the legal name change of tastylive. As a result, this video may reference tastytrade, its prior legal name.

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