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So, hedge funds are in trouble. How do we play it?

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August 12, 2007 – Comments (1)

By you've probably picked up on at least some of the reports about hedge funds being forced to liquidate assets to cover redemptions, answer margin calls, etc.  Not only has CNBC been mentioning it, but the stories have appeared in the WSJ and this weekend's Barron's was full of stories about big money funds that are having problems.

Basically, what's happening is at least some of the leveraged big funds have racked up some pretty big losses in the various flavors of collateralized debt paper.  Unhappy investors are pulling money out, lenders are demanding the funds raise money to meet the debt terms and the servicing brokerages are making margin calls against the short positions.  Since there isn't much market for the debt paper they've got, they've been raising money by selling what they can sell - quality stocks, gold, etc. and using the money to pay for redemptions and cover short positions.

That would explain what we've been seeing the last few weeks, funds selling quality stocks would hammer those prices and short covering would explain some of the weaker sectors seeing price increases.

I have no clue how far we are into this process, but it should represent a great opportunity to pick up quality stocks at fire sale prices as the big guys get backed into a corner. The tough part will be identifying when the final clearance sale starts. One signal to watch for will be stories about hedge funds liquidating assets showing up in the mainstream press, e.g. when it makes the front page of the New York Times, it'll be nearly over.

I'm considering playing this market by placing small limit orders with lowball bids or premium ask prices and look for market volatility to generate some steals and deals.  I don't have the time or inclination to watch tickers all day, but this market would seem to be well suited for traders.

Please feel free to add your thoughts on how to play this market.

Have a great week and thanks for reading. 

1 Comments – Post Your Own

#1) On August 13, 2007 at 4:24 AM, LongVol (< 20) wrote:

I think you are right on the money here.

Watching the tick action Friday was quite interesting,
as you could see individual issues being pushed up or
down in isolated, uncorrelated (no associated derivative)
movements.

After scratching ones' head, the expalnation of unwinds
is certainly reasonable (and acceptable).

Whether or not it will continue or will result in such wide
swings remains to be seen, volatility models would say that
the swings will become less and less pronounced until returning
to pre-shock levels, but who is to say when that will be..

If the trading floors haven't maxed out their time-bucket risk
quotas, then some support will be there to keep the swings
somewhat controlled via the volatility arb.

But putting in orders above and below and waiting to get picked
off in long quality and/or short crap sounds right as the sky is probably
not falling , it never seems to, does it.

The swings may just not be as violent .. you have to consider that the
trading floors have tweaked their models to pick off a bit more as well..

Good luck ..

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