| I don't believe that LTCM was insuring anything. What they were doing is identifying pairs of securities whose values had diverged and they believed would eventually converge. They would short the more expensive one and buy the cheap one. When they converged they would sell the no longer cheap one, use the money to close out the no longer expensive one, and collect a profit. However usually the reason why one was more expensive is that it had a more liquid market. So people could safely invest in it with money that they might need back quickly. This shouldn't matter if you planned to buy and hold though..at least in theory. But in the wake of the Russian default, liquidity became more valued. So people sought to get rid of illiquid securities and buy liquid ones. This meant that LTCM had shorted things that were rising in value, and bought things that were falling in value. So they had a loss. And as the shorts got higher, they wound up having to sell assets at a loss to cover their shorts. And now the temporary losses became very real ones, and drove them bankrupt. However, infamously, their investments made money in the end. They just weren't able to last long enough to benefit from it. |
While most of their strategy was convergence arbitrage, if I recall from the book, they thought of selling short equity options as a form of selling insurance.
People buy these options to insure against some event and they expected more buyers than sellers, so LTCM figured they would profitably be the provider of it. Well-structured insurance is always a loss to the buyer (they take in more than they pay out).