The Silverado Strategy: Enhanced-return event-based investing with options
Silverado has designed an innovative means to enhance returns from event-based opportunities through the use of individual stock options.
Over the last five years, event-based investing, particularly risk arbitrage, has developed weaknesses that the traditional application of the strategy has not effectively countered, namely:
• Excessive allocation of funds to the strategy has resulted in very tight spreads with unattractive risk/reward ratios that limit returns;
• Low interest rates enable cheap leverage, accentuating the effects of excessive allocation of funds;
• Event-based investing has become institutionalized, with universally available research, dramatically reducing an event-based portfolio manager's "edge" and ability to innovate.
Instead of using the common equity of companies involved in restructuring or M&A, Silverado invests using option spreads that have a definitive cost and the potential for substantially greater returns.
The research to support this methodology is exactly the same as the traditional event-based strategy -- exploring corporate governance, fundamental business circumstances, antitrust or regulatory issues, and other possible catalyst impediments remain the same. Accurate forecasts of timing so that investment opportunities can be compared based on annualized return also remains the same.
The difference is not in identifying the opportunity, but in identifying how to maximize the return from taking on the risk associated with the opportunity. Silverado has over thirty years of experience with this research process.
Siverados believes its strategy is not inordinately complex. It states: "The barriers to entry to prevent competitors from adopting a similar approach are not high. The options that the strategy trades are regular listed options -- they are not exotic and they are not over-the-counter. And yet, few hedge funds of size would spend the time and effort necessary to identify optimal investments because this approach cannot absorb huge amounts of capital (i.e. hundreds of millions or billions of dollars). Silverado believes its size and agility is a competitive advantage. "
In addition, the firm's professionals are experienced investors in convertible arbitrage and risk arbitrage opportunities, accustomed to trading derivative securities because that is a critical element of convertible arbitrage, and they are also accustomed to trading spreads -- a critical element of risk arbitrage. Because of their experience, Silverado believes the specific trading involved in applying the strategy is second nature to the firm.
By applying the same research process that is applied in traditional event-based investing to option spreads, Silverado is able to invest with a fixed, known, downside risk. In a strategy where negative events can eliminate positive returns not only from a specific position, but for the entire portfolio, the significance of quantified risk cannot be overstated. All too often, unexpected events (accounting irregularities, fraud, corporate scandals, lawsuits, industry- or economy-wide phenomenon) can result in an investment that is trading below the downside target that was estimated when the position was established. A traditional risk arbitrageur's downside risk analysis produces an estimate of risk with questionable accuracy.
In contrast, when Silverado invests in an option position, the downside risk is limited to the invested capital only. An equity purchased at USD 30 can trade below the portfolio manager's expected downside, but a call spread purchased at USD 3 cannot trade lower than USD 0. By investing with options, Silverado caps the effect of unforeseen events on the portfolio.
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