End of the year trading strategy: Whack-a-Mole

This strategy is focused on small–cap stocks, not prediction markets, and is similar to the whack-a-mole carnival game. In the entertaining boardwalk staple players use a mallet to smash the heads of any mechanical moles foolish to stick them out, the more you smashed the better you did. The idea here is to short as many small-caps as we can that have an end of the year bump during the last days of trading.

Although we haven’t seen it in the last week, financial publications at this time of year talk frequently about an, “end of the year rally.” Rather than traders squaring away positions before the New Year, hedge funds and money managers participate in a year-end scramble to “paint the tape” or run up their portfolio solely for valuation purposes. The reason this occurs is because absolute returns for money managers DO NOT MATTER. What matters is beating the benchmark.

How managers get paid is by the % that they exceed the benchmark for a period. Since valuations are normally done at the end of the quarter many Wall St. participants have incentive to run up their equities on the valuation date to get the maximum bonus possible. Of course since there is no fundamental change in valuation, stocks fall back down after the date passes. The reason it is so pronounced at the end of the year (in theory) is that there is a big decrease in volume so it’s easier for the pros to push the market around.

Since we don’t have to meet benchmarks, we can trade with a focus on returns not short term chicanery. Rather than guess who owns what and who has incentive to paint the tape we can screen for small caps that have gone up 5% or more this past week with no change in fundamental and short as many of them as we can. Short term and simple, everyone that sticks out we hit back down.

Unfortunately, with the Dow flat we may see fewer opportunities than last year so focus on sector bets that have had a gain to beat.

High Prices and Large Spreads: The Effect of Transaction Costs and Excess Choices in Prediction Markets

Looking at the Academy Award for Best Actor we can see that the current offers add up to 218.2, very overpriced. Since the prices of the contracts are approximately the percent chance of the contract paying off we can tell the market is overvalued. If everything was priced accurately the percentages should add up to around 100 (it will always be a little more due to the spread). Think of an election with two candidates; there will only be one winner. The chances of success for both candidates should add up to 100%, e.g. Candidate A has a 30% chance of winning so Candidate B should be at 70%. The highest chance of someone winning is 100%, so if the market is factoring in more than that it is over exuberant.

Since the market is factoring in over 200% chances of winning the Best Actor Academy Award there should be several opportunities to short the market. Unfortunately when we look at the sell side, the spread is so wide that the opportunities disappear. The Bids total up to only 92%. Not only are the spreads wide but in some cases the other side of the trade doesn’t exist. For instance on Crowe as Best Actor the Offer is 4.9 with 0 on the bid. What is happening here is that the chance of Crowe winning is so small that there is no incentive to take the other side of a guaranteed losing trade. In theory the contract can trade low enough to generate interest, but because of transactions costs it isn’t going to happen. No one can make money selling at the real odds so the market ceases to exist.

That leads to the next reason why the huge disparity between bids and offers exists; too many betting choices. With so many options, each with their own bids and offers, the market has trouble closing the gap. For instance, the GOP Nomination has 26 different candidates that you can take a position on. With volume of over 80,000 contracts the market is fairly deep but the spread between the bid and offer has stubbornly refused to close and remains at 21.3 (Bid 96.6 – Offer 117.9). Similar to our trader who will sell Crowe at 4.9 but wouldn’t buy at any price, the long shots skew the market. The more choices, the wider the gap between the bids and offers, even when sufficient liquidity exists. Looking at the Canadian Elections, a trade with only three choices, we can see more rational pricing. The spread is only 7.25 (Bid 98.2 – Offer 105.5) even though liquidity per contract is substantially similar to the GOP Nomination (3,076 GOP vs. 3,259 CAD contracts traded).

Not only is contract volume a factor in closing the spread between bid and offers, the number of choices are as well. However we expect the market to rationalize as the expiration approaches and the smart money begins to pay more attention.

Academy Award Best Picture Bet - TradeSports

The Bet

With two movies breaking away from the pack and the rest of the films with only small chances of winning at current levels, we can make a safer bet than by just picking one film by playing the odds. ‘Brokeback Mountain’ and ‘Munich’, trading at 40 and 32 respectively, are the clear favourites and although I'm rooting for ‘Brokeback’, we can lower the risk and lock in profits by betting smarter.

The contracts in this market are binary and will only end up at either 100 (where each contract pays $10) or 0. With only one winner and two favorites, we can think of the bet as to a presidential election where the two candidates are trading in the 40's (the level of trading are the approximate odds that the bet will pay off). Since we know one will win, as long as the contracts are trading low enough we can arb the market for a safe profit.

As present levels if Munich wins, the contract pays 6.8 and we lose the premium on Brokeback of 4.0, but lock in the spread. As long as the Buy side of both contracts is trading lower 100 total (absent of transaction costs) the opportunity exists.

Some issues with the trade exist, the most obvious being a surprise victory of one of the other films. The closest contract right now is ‘Good Night and Good Luck’ trading at 10 (a level I’d sell at all day) but that seems very unlikely to win. On a practical level the issue is liquidity, the market has very little depth which may be the reason that the opportunity even exists in the first place.