Hedge fund naked put selling

Filed in archive Companies and Markets on May 16, 2005

Wild stories and rumors from london to new york and around the world. Hit hedge funds these last two weeks . Which intern has opened prying eyes in a field that likes to hide.

And we look at the dead ends, funds are hitting below:

The debt downgrades of GM (ticker: GM) and Ford (F) helped trigger both the recent decline in stocks and the widening in credit spreads, or yield differentials, which helped drag down convertibles prices.

Hedge-fund selling caused the most dramatic valuation collapse," largely because of the unraveling of convertible-arbitrage strategies employed by these funds. In their most basic form, these strategies involved purchasing a convertible and simultaneously selling short the underlying common stock against the call part of the convertible. In order to capture the fixed-income portion while hedging the equity risk.( many funds try to magnify returns with leverage).

But in the real world of trading, they are just selling Naked puts. ( buy a Stock, sell its call = naked put )

..And yes hard to believe , but 90% of the managers who do these trades don't seem to understand... This is the reason we saw selling the last few weeks, in the big caps who have a large amount of Convertibles.

Because If your naked the put , you must sell to protect your position.

Convertibles are hybrid securities, either bonds or preferred stock, that can be exchanged for a predetermined number of common shares( Bond and Stock Option combined ).This lets an investor participate in stock-price changes, but with the yield and greater security of a fixed-income instrument.