All investments are risky. The techniques explained in this series are exceptionally risky. I am not a registered investor, attorney, advisor, broker, banker, lawyer, dealer or anything of the sort. All opinions expressed here are for my personal exploration. I present it to you for entertainment. This post may help you understand policies related to financial regulation for the purposes of more informed voting. This post is not investment advice. This post may contain errors.
There are two ways to profit from the stock market: alpha and beta . Extracting rent from your ownership of capital is called . Arbitraging away market inefficiencies is called .
Arbitrage has two components: inefficiencies and hedging.
You start by spotting a market inefficiency. In the previous post, a futures contract price constituted a market inefficiency. Wherever there is a market inefficiency there is the opportunity to earn money on average. But we are not interested in earning money on average. We care about risk-adjusted returns.
Once you have discovered a market inefficiency the second thing you do is construct a financial derivative to hedge away as much risk as you can.
In the first example of the previous post, we created an artificial future by buying the underlying security with borrowed money. In the second example of the previous post, we artificially shorted the future by shorting the underlying security and then lending the resultant cash as a bond. These artificial futures hedged our risk from the original mispriced future. We earned a profit of exactly independent of how the actual price behaved.
In addition to eliminating our risk, our hedge also removed the necessity of tying up capital. In theory, our futures trading algorithm required zero underlying capital. It is constructed from pure leverage. We can continue the strategy over and over again until drops below our transaction costs. (Actually, we can continue the strategy over and over again until we are issued a margin call.)
In this way, financial derivatives let you use the magic of leverage to gamble assets worth far more than your capital holdings.
As another example, suppose you knew Tesla will go up 1% in value over the next month. If you are a normal human being then you might consider buying Tesla stock. But if you have been following along so far then you understand why "buying Tesla stock" is almost completely wrong. What should you do instead?
As we showed in the previous post, the price of Tesla futures is a function of the present stock price and the bond rate and has nothing to do with the fact Tesla stock is going to increase in value over the next month. The bond rate is unlikely to exceed ROI per year. (In the unusual circumstance it does, then just add a negative sign to everything.) Borrow money at the bond rate and buy Tesla futures expiring in one month. Repeat until you run out of credit or until the present Tesla price represents the future-discounted price .
Our better solution involves no capital investment. It is pure leverage.
As before, this trading strategy is theoretical. There are hidden risks I have not addressed yet.