Invisible Interest Rate Cut
Trading, as you can imagine,
has been active to say the least. The CBOE volatility index
(
VIX |
Quote |
Chart |
News |
PowerRating) that peaked
on Friday morning at 58%, is back to what we used to think was a stratospheric
41%. Clearly, not everything is all right with the world, but we are seeing a
great bounce from our severely oversold condition.
I’m sorry our active trading kept me from completing the discussion so many of
you had asked for regarding the “invisible interest rate cut." Here is the
down and dirty on what happened and how it could effect trading.
When professionals sell stock short, we not only stand to profit from a decrease
in share price, but also from the interest paid on the dollar value of the
stocks we have sold. For instance, if I sell 20,000 IBM at $94.22, I will get
interest on the $1,884,400 — as if I deposited cash into my bank account. The
firm that lent me the shares will usually take a cut of 5 — 15% of the
interest on that $1.8 million, but the rest is profit to me.
When calculating “Fair Value†for the future vs. the cash, I take the
interest I will be paid, multiply that by the number of days until expiration,
and multiply that by the cash value of the index. Finally, we divide that number by
360 (short cut for days in the year). Since there are always dividends that will
be owed for the stock we sold, we subtract those from the total.
That looks like this:
Fair Value = .0375 x 90 x 1002/360 minus dividends.
When an Arb firm has a short basket of stocks vs. the S&P 500 futures,
that firm is locked in an arbitrage that can move against them in two primary
ways:
1) interest rates drop; or 2) dividends increase
What happened last week was that the
clearing firms lowered the interest rate paid (on short stock) or charged
(to carry long stock) from 3.75% to 1.75%. This was not an announced Fed cut,
but simply an action that made tons of cheap cash available to professional
market makers. This effectively shrank the Fair Value considerably and while
that move wasn’t permanent (rates have moved back up to about 3.75%) it
definitely had an impact on program trading and the arbitrage capture game.
I have to offer kudos to Benji Schwartz of JHWK Trading, a regular on “Doctor
J & the Tradersâ€, as he called the bottom last Friday. One must note that
while Benji sees a bounce coming, he anticipates a slide below 7900 to 5800 for
the Dow before the present bear market is over.