Deleveraging As a Strategy

We recently are aware of some of the issues relating to hedge fund's applying too much leverage in various forms which lead to inflated equity prices. If you had recognized the pattern, was there a profit opportunity?

While many people were applying leverage to obtain higher returns from equity, contrarian investors with a great deal of foresight could have applied deleveraging as a strategy.

Deleveraging has traditionally be used as a moderate hedging strategy in order to offset tax claims, however, in this scenario, it could have provided a great profit. Here's how it works.

Leverage is simply borrowing money to buy more of a stock. The profit potential arrises when the stock appreciates faster than the interest yield (owed) on the loan.

A contrarian investor notices a great deal of leveraged activity in the market. Seeing a bubble beginning to form outside of a reasonable valuation for these equities, the investor takes a short position against the equities. The cash provided by this short position, the investor would put back into the market in the form of a bond.

By taking this position, the investor can arbitrage the debt out of the security to bring it back to expected level. The profit is made from the short position when the stock price starts to drop (because it's over sold) and also from long position in the bond from the interest collected.

Inherent risks in any position is if you guess wrong. In this case, if the stock price goes up faster than the interest collected by the bond. This would imply that the market still has some room to apply leverage.