Volatility Arbitrage:: The Non-Correlated Alternative

July 2006 l volatility arbitrage supplement
THE VOICE OF THE ALTERNATIVE INVESTMENT INDUSTRY
In association with
Volatility Arbitrage:
The non-correlated alternative
BEGINNER’S GUIDE: FUND PROFILES: INTELLECTUAL PROPERTY: PAY DAY:
From delta to gamma Cream of the crop R&D sharpens the edge Option pay-offs
Fimat’s James Skeggs explains the Profiles of Shooter FM, In volatility arbitrage are two Fimat explains the pay-off profiles
terms, strategies and positions ABC Square AM, Société Générale kinds of funds: the adaptive with of the various positions volatility
employed in volatility AM, and Titan Capital Group, as foresight, and the dead.The strat- arbitrage fund managers can use,
arbitrage – and how well as Acorn Derivatives. egy’s top managers explain how and explains which strategy works
it can help diversify R&D hones their best in each
your portfolio winning edge environment
04 10 15 18
VOLATILITY ARBITRAGE REPORT
Contents
Publisher 4-9 The A-Z of volatility arbitrage
Jonathan Greene From delta to gamma to straddles and strangles, James Skeggs from prime broker Fimat explains
+44 (0)20 7484 9867
jonathan.greene@incisivemedia.com how volatility arbitrage makes money for its investors – come hell or becalmed markets.
Managing Director 10-11 From little acorns...
Matthew Crabbe
+44 (0)20 7484 9814 Acorn Derivatives explains what makes their fund tick.
matthew.crabbe@incisivemedia.com
12-13 Squaring up to the competition
Editor
David Walker London’s ABC Square Asset Management describes its trading philosophy, and the approach to
+44 (0)20 7484 9889 trading long and short volatility. It has seen its Sigma Square fund produce 4.5% returns for its
david.walker@incisivemedia.com
investors in 2006, to 31 May. ABC Square AM’s Peng Tang explains how it works.
Staff writer
Solomon Teague 15 Constant evolution
+44 (0)20 7484 9811
solomon.teague@incisivemedia.com Volatility arbitrage is not just about switching on the machine and sitting back – a diligent
commitment to research and development is essential, as the leading managers explain. We reveal
Reporter/sub-editor
Jay Blanche which markets they are researching, which ones need greater attention, and how R&D has reaped
+44 (0)20 7484 9923 rewards.
jay.blanche@incisivemedia.com
Graphs thanks to
16-17 On target
Susan Billinge David Beddington from Shooter Fund Management explains how reaching the overall targets
for returns from the Shooter Multi-Strategy Fund involves spreading the sources of those return,
Production
Ross Harman producing few days when all strategies hit their straps, but equally few days where little is working.
+44 (0)20 7484 9965
ross.harman@incisivemedia.com 18 Pay-offs
Advertising James Skeggs from Fimat explains the different option pay-off profiles, and explains which options
Philip Ansley strategies can be used to best effect, depending on the market conditions and expense of
+44 (0)20 7968 4514 employing the strategy in question.
philip.ansley@incisivemedia.com
Head office 19 A mirror to volatility?

Haymarket House When commentators speak of ‘market volatility’ they speak most often of the VIX or VDax
28-29 Haymarket
London SW1Y 4RX indices. But the jury remains out on whether these benchmarks accurately reflect the volatility in
the relevant market. David Walker investigates.
Artwork: Georgina Kenyon,
georginakenyon@hotmail.com 20-21 Plus ça change
Editorial/advertising fax Société Générale’s Bernard Kalfon explains why volatility arbitrage is sustainable as a strategy and
+44 (0)20 7930 2238 how Société Générale Asset Management goes about constructing and monitoring the portfolio of
Subscription and circulation its SGAM AI Global Volatility Fund.
enquiries
+44 (0)20 7484 9890 22-23 Universal appeal with a regional twist
Published by
Titan Capital Group has developed regional volatility arbitrage portfolios for the US and Asia, to
Incisive Media Plc add to its global offering. Russell Abrams from Titan explains how the regions’ characteristics differ
from one another, and how Titan employs a robust process across all its portfolios.
Printed by
Heron
www.hedgefundsreview.com July 2006 | VOLATILITY ARBITRAGE SUPPLEMENT | 3

VOLATILITY ARBITRAGE EXPLAINED
Welcome turbulence – how to mak

Don’t know your gamma from your theta, or your butterflies from your condors? James
Skeggs from prime broker Fimat explains the terms of volatility arbitrage, and how the
strategy’s managers apply them to make money from a bumpy ride
The trading of volatility as an asset The differences, however, are due Indeed, volatility is often referred The forward-looking, or implied,
class is by no means a new phenom- to the fact that the bond component to as a ‘fear gauge,’ as it tends to volatility is somewhat more difficult
enon as proprietary traders within also introduces issues with respect to grow when uncertainty increases (for to calculate, and represents the uncer-
investment banks, and options mar- credit risk. Managers trading volatil- example, when the discounted value tainty about future prices.
ket-makers have been trading volatility will seek to avoid this risk by only of future cash flows for an asset are It is one factor of the risk pre-
ity for many years. trading the option component. harder to predict, uncertainty about mium, and thus should also be con-
However, the methods of trading Despite the recent growth in the the value of the asset increases, and sidered when looking at actively
this asset class have been slow to number of funds trading volatility, greater, or more frequent, price move- managed portfolios.
move out from the banks, and there barriers to entry still exist. ments are experienced). Implied volatility is one of the
are still a limited number of stand- These include lack of options When considering volatility, it is parameters used when calculating
alone funds trading pure volatility. expertise, the complexity of posi- important that one looks both at the value of options, for example,
More recently, there has also been tions and modelling volatility (lack forward (implied volatility) as well using the Black-Scholes pricing
a shift in the way volatility pro- of historical data), and the recent low- as at backward (historical or statisti- model, and is the only one that can-
grammes are perceived; from an volatility market. Transaction costs cal volatility). not be directly observed.
insurance type of product to an are also relatively high for parties The historical volatility of a secu- Thus, if we know the price of an
absolute-return or portable-alpha outside banks or market counterpar- rity is the actual volatility experi- option (available through market) then
product with outperformance being ties, though these costs have reduced enced over a given time frame, and we are capable of implying the mar-
exhibited in times of market stress. markedly in recent years, leading to an is important when analysing hedge ket’s expectation of future volatility
Historically, when investors want- opening up of this strategy through fund returns. by using iterative methods.
ed to buy volatility exposure, they stand-alone funds, and as components It can be easily calculated using one
would invest in convertible arbitrage of the large multi-strategy funds. of two methods: Black-Scholes Option-Pricing Model:
managers, and there are significant There has been much said about S = Current underlying price
similarities between convertible and the recent decline in both implied and ■ The standard deviation (σ) of the X = Exercise price
volatility arbitrage. historical market volatilities – a trend returns of the security over the time T = Time to expiry
However, there are also some particularly noticeable in equity indi- period: R = Interest rate
important differences. Convertible ces1, FX, and credit spreads. However,  Si  1 n σ = Volatility of underlying
securities first appeared in the US in commodities markets have seen rising ui = In  σ =
S  ∑ (ui − u )2
n − 1 i =1 Call price = SN (d1 ) − Xe N (d2 )
i −1 − RT
the 1800s, and the notion of arbitrage historical and implied volatilities, par-
(that is, profiting from the mispric- ticularly in base metals.
σ2 
ing of convertibles by hedging long
positions in convertible bonds with WHAT IS VOLATILITY?
■ The average true range (ATR) of
the prices of the security over the time ( ) 
ln S X +  R +
 2 
T
short positions in common stock) Before we explore the trading of vola- period: where d1 =
was introduced by Meyer Weinstein tility as a strategy in more detail, it is ATR = n-day average of the maxi- σ T
in 1931. important to understand the concepts mum of the absolute value of the
Convertible bonds can be regard- of volatility. The volatility of a secu- following: and d2 = d1 − σ T
ed as a straight bond plus a war- rity can be seen as the uncertainty (or
rant. It is the option component that riskiness) of the returns, or alterna- ■ Current high less current low where N ( d x ) is the cumulative prob-
causes comparisons with volatility tively the degree of fluctuation about ■ Current high less previous close ability distribution function for the
strategies. a price trend in that security. ■ Current low less previous close standard normal distribution.
PRICE VS FRONT MONTH ATM CALL IMPLIED VOL VS 60-DAY HISTORICAL VOL CHART 2: VODAFONE 130 CALL OPTIONS
30 25
SPX Index
Implied volatility (%)
1300 Price
Call option price
Front Month ATM Call Implied Vol 25

60 Day Historic Vol 20
1200
20
15
1100
15
10
1000
10 7 Days
30 Days
5 90 Days
900 5 180 Days
365 Days
800 0 0 Expiry
2003 2004 2005 2006 Stock Price
10 April 2003 - 10 April 2006. Source: Fimat Alternative Investment Solutions Source: Fimat Alternative Investment Solutions
4 | VOLATILITY ARBITRAGE SUPPLEMENT | July 2006 www.hedgefundsreview.com

ke money from volatility arbitrage

AN INTRODUCTION DIRECTIONAL VOL TRADING who are option-sellers (short volatil- costs, lack of perfect knowledge about
Having looked at the basic con- The most popular method of trading ity) are expecting to capture by sell- future volatility, and the fact that
cepts behind volatility, we will now volatility by institutional parties and ing the option then profiting as the market movements are not smooth
explore in some more detail the ways hedge funds is by using options. A theta falls to zero. (this is one of the basic assumptions
that fund managers trade volatility, simple directional position using Managers long volatility talk of of the B-S option pricing model).
and also how they aim to profit from options (such as long volatility) would “bleeding through theta”, as it repre- In reality, hedging is done on a dis-
this trading. be a long position in a call-option con- sents a loss for holding the options if crete (disjointed) basis.
In a similar way to more tradi- tract, and short position in the actual the price of the underlying security The ideal market conditions for a
tional strategies, volatility traders underlying. doesn’t move. long volatility strategy are nervous
can take a number of different posi- The position would initially be con- ones with large price movements
tions from the following: structed to be delta-neutral (that is, DELTA AND GAMMA either up or down, but around the
by shorting a number of stocks equal The simple long vol example, strike price, where gamma is maxim-
Directional views on volatility to the delta2 of the options held in the however, is not a clean position in ised. These conditions give the trader
(for example, long or short) long position). volatility as the delta is not a linear the maximum opportunity to gamma
■ Trade the implied volatility versus When considering the profitability function of the underlying price. trade, and therefore to try to offset the
historical volatility on the same asset of the above example, we need to The delta of an option also dem- theta loss.
(gamma trading) include the premium that has to be onstrates some curvilinear properties The long volatility trader will lose
Across different strike prices paid when buying the option. (see chart 3, below), and thus traders money if the realised volatility for
Across different maturities This has the effect of reducing the will look to re-hedge their positions the duration of the position is lower
profitability by the cost of the option. following a large move in the market, than the implied volatility when the
Relative-value positions in In this scenario, the price needs to as a position that was initially delta- position is initiated. The worst-case
volatility positions move by a certain amount in either neutral will have ceased to be so. scenario is a market with no volatility.
■ Trade the implied volatility versus direction in order for the position to The property of the option that is
the implied volatility for the same be profitable – hence why this is a used to describe this is the Gamma STRADDLES AND STRANGLES,
asset (known as ‘volatility-surface long position in volatility. of the option, and the continual re- BUTTERFLIES AND CONDORS
arbitrage’) It is also necessary to consider hedging of the portfolio is called Long directional positions on
other costs for holding options posi- gamma trading. The aim of gamma volatility can also be constructed
■ Trade the implied volatility versus tions, particularly the concept of time trading is to capture sufficient through combinations of options.
the implied volatility for a different decay for options, or ‘theta’. trades to cover the theta (time decay) The simplest of these positions is a
asset of the option – managers call this straddle position (see chart 5, over-
Long/short volatility THETA the ‘gamma rent’. Options that are leaf), which involves buying a call
Dispersion trades An option’s theta is the rate of near the money, and have a short and put option on the same under-
change of the value of the option time period to expiry will tend to lying, at the same strike price, and
Traders taking directional posi- with respect to the passage of time, exhibit higher gamma’s, and thus at the same maturity.
tions on pure volatility are insensitive assuming all else stays equal. The provide more re-hedging potential. This type of position would be
to the actual direction of the under- theta of an option tends to be nega- However, these type of options also used when the trader is expecting the
lying market. Those taking a long tive, that is, the value of the option tend to exhibit high thetas. market to move sharply, but doesn’t
position in volatility are expecting a will fall over time, and theta becomes It is therefore vital that the trader have any particular view on the direc-
rise in volatility, that is, they expect zero at maturity. It is this feature that examines the size of the price move- tion that the breakout will occur in.
increased fluctuations in the price of leads to the term ‘theta decay.’ Near- ment in the underlying that will be Similar positions, known as a
the underlying security, rather than the-money options tend to have the required to enable the position to strangles, are constructed by com-
an increase in the price of the under- highest values for theta, and as you cover the loss through theta. bining a long position in a call option
lying security. move further away from the exercise In an ideal world, a long volatility and a put option on the same under-
As in other markets, relative value price, the effect of theta is smaller. position would be continuously re- lying, and the same maturity, but at
positions aim to capture mispricings (See chart 2, facing page). Theta is hedged, however in practice this is not different strike prices. These posi-
in volatility. one of the features that managers always possible due to transaction tions are cheaper to implement, as
CHART 3: STRIKE PRICE AND DELTA CHART 4: RWE 06/06 C 74 – GAMMA FOR 1000 LOTS (DATE = PRICING DATE,
VERTICAL LEFT HAND AXIS IS GAMMA)
1.2
Delta
May
1.0 Jun 3.50E+04
Sep 3.00E+04
0.8 Dec
2.50E+04
0.6 2.00E+04
1.50E+04
0.4 1.00E+04
5000E+03 14 Jun
12 Jun
0.2 +00 10 Jun
106% 8 Jun
6 Jun
102% 4 Jun
0.0 2 Jun
98%
100 103 106 109 112 115 118 121 124 127 130 133 136 139 142 145 148 31 May
Profitable path 94% 29 May
Strike Price Costly path 27 May
Source: Fimat Alternative Investment Solutions 90% 25 May
Source: ABC Square Asset Management LLP/Fimat Alternative Investment Solutions

Welcome turbulence – how to mak

CHART 5: LONG STRADDLE be tempted to take the other side of will aim to sell options that are near that are either deeply in-the-money, or
the long volatility positions by writing the money in order to maximise deeply out-of-the-money have higher
(selling) options to capture the option their potential profits though the volatilities than we would expect
premium. In this case, the trader is theta decay, though there is more (due to their increased likelihood than
taking a short volatility position, risk of exercise for the option (also would be predicted by the Black-
that is expecting price movements known as ‘pin risk’). Short vola- Scholes model).
to be small, and is looking to benefit tility positions such as the short If we plot the implied volatility as
from the time decay (theta) of the straddle, have the potential for a function of the underlying price, we
option. large losses should the underlying can see a ‘smile’, which is known as
Traders may also put on short price move sharply in either direc- vertical skew.3 (See chart 10, below).
volatility positions if they believe tion. To limit these potential losses, A simple strategy that is traded
that prices of the underlying asset the manager may like to cap the when this smile exists is simultane-
will stabilise going forward. These maximum downside risk, though ously to buy the cheaper option in
these positions, called either butter- volatility terms (that is, cheaper once
the options with strikes further from CHART 7: A SHORT STRADDLE flies or condors, are more expensive the time value of the option has been
the current underlying price will have to initiate. A long butterfly position discounted – this tends to be nearer
a lower theta, however, they require (chart 8) is constructed by buying the money), and sell the more expen-
larger moves in either direction to be two call options at different strikes, sive option in volatility terms (further
profitable.” and also selling two call options out of the money) on the same under-
If the trader has a view on which at the same strike in the middle of lying, and at the same expiry.
direction he thinks the market will the two long call strikes, with all This type of spread trade can be
break to – for example, he expects options for the same expiry. constructed using either put or call
the market to move down following Condors (chart 9) are similar to options.
an overextended period of gains – he butterflies but the two short call If the trader has a negative view
options at the centre are at different on the underlying market, put options
CHART 6: A LONG STRANGLE strikes as well. would be used (called a bear spread).
If the trader is positive on the market,
RELATIVE-VALUE a bull spread would be implemented
CHART 8: BUTTERFLY POSITION VOLATILITY TRADING using call options.
Volatility surface trading The other form of skew that exists
Volatility surface arbitrage is the term for options in the horizontal skew, in
used to describe the relative value which options further from expiry are
trading of the implied volatilities of cheaper in volatility terms than those
two options on the same underlying. near expiry.
The opportunities for the strategy In order to trade this skew, the
arise due to differences between the trader can sell the expensive options
theoretical models used in options in volatility terms (near to expiry) and
pricing, and the reality. buy the cheaper options (further from
For example, the Black-Scholes expiry).
can structure positions that provide Option-Pricing Model assumes that This is called a calendar spread,
profits in that direction only. the returns of the underlying are dis- and the trader aims to profit through
These positions (for the same time CHART 9: A CONDOR POSITION tributed in a lognormal fashion, how- time decay.
periods) are cheaper again than the ever in reality, this is not the case as When the underlying markets
straddle or strangle positions. extreme price movements occur more experience a rapid fall, both the hori-
However, they do not allow the frequently than would be predicted zontal and vertical skew can become
trader to profit should the market by the normal distribution. exaggerated, providing a good
move sharply in the unexpected direc- This type of distribution is usually trading opportunity.
tion. These positions are known as 1 called ‘fat-tailed’, or leptokurtic. This position is called a back
by 2 spreads (or short ratio spreads), The effect of this is that options spread, and consists of a long position
and they can be constructed using
either put options (1 by 2 put spread) CHART 10: US LONG BOND 108 CALL AT 108-06
or call options (1 by 2 call spreads)
depending on the direction the trader 40
Implied volatility
wants to gain exposure to. positions will profit by selling high- 35 May Jul
Jun Sep
The options used to construct these implied volatility, and then subse- 30
positions will again preferably be the quently realising low volatility. 25
options with higher levels of gamma Simple short volatility positions
20
to enable active re-hedging should the can be structured by selling strad-
deltas change rapidly (that is, through dles or strangles to the long vola- 15
a market ramp or crash). tility trader that is, selling a call 10
option and a put option on the same 5
SHORT VOLATILITY TRADING underlying at the same strike price 0
Due to the zero-sum nature of deriva- (in the case of a short straddle, or
94 96 98 100 102 104 106 108 110 112 114 116 118 120 122
tive instruments, other traders may at different strike prices for the
believe that options are overpriced short strangle). Strike Price
(implied volatilities are high), and will As mentioned previously, they Source: Fimat Alternative Investment Solutions

ke money from volatility arbitrage options on the S&P500 Index. tools as they provide the purest
CHART 11: US LONG BOND 108, CALL AT 108-06 The CBOE has also launched volatility exposure. In the foreign
10 the VXN Index, which tracks the exchange markets, however, the
implied volatility of the Nasdaq smile is slight, and volatility swaps
Historical volatility
9
100 Index, and other exchanges can be used, as there is less of a
8
have launched volatility indices, for requirement for a perfect hedge.
7 example Deutsche Borse’s VDAX Variance swaps are also widely
6 and V2X Indices, which track the used by traders as speculative
Apr May Jun Jul Aug Sep Oct Nov
implied volatility of European instruments on volatility.
2006
equity market implied volatility.
Source: Fimat Alternative Investment Solutions
Volatility exposure can also be BENCHMARKING VOLATILITY
easily gained through volatility and When looking at investments, we
variance swaps. are often inclined to assign bench-
CHART 12: US LONG BOND 108, CALL AT 108-06 Volatility swaps are over-the- marks to give indications of relative
counter contracts on future realised performance. In volatility, we would
40 volatility, whereas variance swaps tend to use the following measures:
Implied volatility
35
30
are based on the square of future ■ Equity market implied volatilities:
25 realised volatility. CBOE VIX (S&P500) and VXN (Nas-
20 The payoff at expiration for a daq 100) Indices, Deutsche Borse
15 volatility swap is as follows: V2X (DJ Euro Stoxx 50) and VDAX
10
5 Payoff = (σR - Kvol) x N where σ is (Dax) Indices
0 the annualised realised stock volatili- ■ Historical volatilities: n-day stand-
94 96 Jun
98 100 102 104 Sep Expiry ty over the period of the swap, Kvol is ard deviation or price changes, or n-
Strike price 106 108
the annualised delivery price, and N day average true-range measures
is the notional amount of the swap. ■ Credit markets: credit spreads
Variance swaps are more widely (spread, for example, between cor-
in an option far from expiry, with a mispricing in volatility, the trader will used in the equity space as the porate bond and a benchmark, for
high strike price; and short position in buy the cheaper implied volatility, demand for put options leads to a example US Treasuries/Libor)
an option near expiry, and low strike and sell the more expensive implied very steep smile, in fact, often more ■ Volatility-trading hedge funds
price. (see chart 12 above). In order to volatility relative to each other. like a slant. Dealers need to hedge (Fimat Volatility Arbitrage Median
remove the underlying market direc- this risk, and so they trade variance a non-investible index of volatility
tion component from the profitability Dispersion trading swaps, which are better hedging hedge fund managers.)
of the trade, the trader will construct Dispersion trading is another form of
the position so that it is delta- neutral. relative-value volatility arbitrage that CHART 13: RELATIVE VALUE VOLATILITY POSITION – NIKKEI VS YEN
If the position is initiated with involves single stock options. This
20 9.2
options on the same futures under- particular strategy involves trad-
Nikkei implied volatility
CLOSE
Yen implied volatility

18 9.0
lying, the position can be delta ing the implied volatilities of single
16 8.8
hedged by buying and selling dif- constituents of an index against the 8.6
14
fering amounts of options because volatility of the actual index, and can 8.4
12
the options for different expiries will be structured as either long or short 8.2
have differing deltas on the same volatility. A long volatility dispersion 10
8.0
futures contract. trade would be long options positions 8 7.8
If the position is initiated with on individual constituents, and short 6 7.6
options on different futures contracts, option positions on an index, such as 4 INITIATE 7.4
the trader will also need to incorpo- through the use of straddles for both 2 Nikkei 7.2
Yen
rate futures contracts into their hedge the long and short legs. This should 0 7.0
for each leg. This, however, does lead prove profitable, as the volatility of Jul Aug Sep
to futures spread risk. an index, being an average of its 2005
components, will tend to move by less Source: Fimat Alternative Investment Solutions
Cross-asset volatility trading than its individual constituents.
Options traders can also put on cross
asset class volatility-based relative OTHER METHODS OF CHART 14: RELATIVE VALUE VOL POSITION – NEWMONT VS GOLD
value positions in order to profit from VOLATILITY EXPOSURE 45 25
There are a number of other basic
mispricings in volatility. An example

Implied volatility spread (%)
40
of this type of position would be methods to take directional trades in 20
35
to trade the volatility of a security volatility. Probably the most simple is
30
against the volatility of a similar, but to buy futures or options contracts on 15
not identical security. the VIX Index. 25
For example, one could trade the The VIX index was introduced in 20
10
implied volatilities of the Japanese 1993 by the Chicago Board Options 15
Yen versus the volatility of the Nikkei Exchange (CBOE), and was origi-
10 New mont Mining 5
(see chart 13, right), or to trade the nally based on at-the-money options Implied Volatility
implied volatilities of gold versus on the S&P 100. In 2003, the CBOE 5 Gold Implied Volatility
Spread
single stock option on a gold producer introduced changes to the calcula- 0 0
(for example Newmont Mining) (see tion method to include options at a 2004 2005 2006
chart 14, right). wider range of strike prices, and the
Irrespective of the reason for the VIX is now derived from the prices of

Welcome turbulence – how to make VOLATILITY IN A PORTFOLIO

Volatility has a number of attractive
price movement (indeed, it tends to
go up when other assets go down
money from volatility arbitrage characteristics (particularly on the

long side) that lead to it being trad-
ed. Firstly, it increases when uncer-
(see chart 16 and 17, below)).
Volatility is also seen as mean-
reverting, which can also be seen by
tainty increases, and is independent the red lines on chart 15, left. Volatility
CHART 15: S&P 500 INDEX AND VIX INDEX of the direction of the underlying positions can also provide an impor-
1480 50
SPX Index
Implied volatility
1380
SPX Index 45 TABLE 1: CORRELATION ANALYSIS SINCE 1990
VIX Index
40
1280 All markets Up markets Down markets
35
1180 30
25 S&P VIX S&P VIX S&P VIX
1080 20
500 Index 500 Index 500 Index
980 15
S&P
10 S&P S&P
880 1 1 500 1
5 500 500
780 0
2001 2002 2003 2004 2005 2006
VIX VIX VIX
-0.65463 1 -0.32629 1 -0.69219 1
Index Index Index
CHART 16: S&P’S 10 WORST DAYS SINCE JANUARY 1990 CHART 17: S&P’S 10 WORST MONTHS SINCE JANUARY 1990
12 25
%
% 10 SPX Index 20 SPX Index
VIX Index 15 VIX Index
8
6 10
4 5
2
0
0 -5
-2
-10
-4
-15
-6
-8 -20
31 30 31 28 28 30 31 28 31 31
27 31 14 17 12 3 27 4 19 15 Aug Sep Aug Feb Sep Nov Jul Jun Mar Aug
Oct Aug Apr Sep Mar Sep Aug Jan Jul Nov 1998 2002 1990 2001 2001 2000 2002 2002 2001 20001
1997 1998 2000 2001 2001 2002 1998 2000 2002 1991
TABLE 2: CORRELATION ANALYSIS JAN 2003 - MARCH 2006 INCLUSIVE. MEASURES RELATIONSHIP BETWEEN VARIOUS RETURNS OVER A
COMMON PERIOD OF TIME.
Correlation analysis from Jan 2003
to Mar 2006 inclusive FVAM VIX Barclay Barclay/ Dow Lehman MSCI RICI S&P S&P/ US dollar
Measures the relationship between the Index CTA GHS Jones ABIx World 500 Citigroup index
fund performance and the performance Index Conv Euro Index BMI
of another fund over a common period Arb Stoxx World
of time Index Index Property
R = +1 indicates that the performance – total ($)
move similarly rtn
R = 0 indicates no relationship
R = –1 indicates an inverse relationship
Fimat Volatility Arbitrage Median 1.000 0.007 0.297 0.132 -0.080 0.233 -0.022 -0.122 -0.028 0.075 0.001
VIX Index 0.007 1.000 -0.168 -0.130 0.672 0.104 -0.587 0.005 -0.668 -0.218 -0.118
Barclay CTA Index 0.297 -0.168 1.000 0.333 0.164 0.299 0.430 0.515 0.376 0.462 -0.407
Barclay/GHS Convertible Arb Index 0.132 -0.130 0.333 1.000 0.068 0.015 0.274 0.244 0.201 0.190 -0.361
Dow Jones Euro Stoxx Index – total rtn -0.080 -0.672 0.164 0.068 1.000 -0.242 0.772 0.016 0.775 0.280 0.145
Lehman Aggregate Bond Index 0.233 0.104 0.299 0.015 -0.242 1.000 0.004 0.014 -0.040 0.321 -0.399
MSCI World Index -0.022 -0.587 0.430 0.274 0.772 0.004 1.000 0.092 0.955 0.629 -0.409
Rogers International Commodities Index -0.122 0.005 0.515 0.244 0.016 0.014 0.092 1.000 -0.017 0.090 -0.153
S&P 500 Price Index -0.028 -0.668 0.376 0.201 0.775 -0.040 0.955 -0.017 1.000 0.562 -0.293
S&P/Citigroup BMI World Property ($) 0.075 -0.218 0.462 0.190 0.280 0.321 0.629 -0.090 0.562 1.000 -0.502
US dollar index 0.001 -0.118 -0.407 -0.361 0.145 -0.399 -0.409 -0.153 -0.293 -0.502 1.000

CHART 18: PERFORMANCE COMPARISON SINCE JANUARY 2003 ■ Historical volatility: 60-day than just opening/closing prices), and
1050 standard deviation of price chang- compare it against the volatility as
es for the S&P 500 Index shown by the 60-day standard devia-
VAMI
1000
VIX Index ■ Volatility traders: FVAMTM. tion of returns.
60 Day Historical Volatility
From chart 18 (to the left of this In chart 19, we can see there is an
FVAM
page), we can see that since January additional (intra-day) volatility active
950 2003, an investment in a manager managers can also capture, which
trading volatility would have out- cannot be captured through passive
900 performed a long position in futures volatility investments (for example,
or options on the VIX (excluding VIX futures, variance/volatility
850
cost of rolling), and would also have swaps). Trading volatility as an
outperformed the realised (histor- asset class is still relatively new as
ical) volatility (the dependent factor a hedge fund strategy, although the
800
for the payoff of a variance or vola- number of hedge funds engaged in
02 2003 2004 2005 2006 tility swap). volatility-trading strategies is on
Source: Fimat Alternative Investment Solutions Some of the main reasons for the increase.
this outperformance are managers’ Investors’ interest is shown by
expertise and managers’ ability to the growth in assets under manage-
CHART 19: S&P HISTORICAL VOLATILITY ANALYSIS capture intra-day volatility not cap- ment in the strategy, and this should
60 tured through the other measures. continue rising, particularly if levels
Historical volatility
60 Day ATR (High/Low) To show this, we take the 60-day of volatility rise from their current,
60 Day Standard Deviation (Open/Close)
50 ATR using high and low prices (rather low levels.
40
FIMAT VOLATILITY ARBITRAGE MEDIAN (FVAMTM) PERFORMANCE
30 In April, the Fimat Volatility Arbitrage
0.15 Median rose by an estimated 0.73%,
20 S&P 500 Price Index bringing its 12-month performance
Annualised return (%)
0.10 to 4.71%. Market volatility has come

10 CSFB Tremont boldly into the spotlight over the last
HFI Managed
0.05 Futures few weeks across all asset classes
0
as the upward trending markets,
2000 2001 2002 2003 2004 2005 06 0.00 experienced for the early part of the
Source: Fimat Alternative Investment Solutions Fimat Volatility year, corrected sharply. The global
-0.05 Arbitrage Median equity markets have seen sharp sell
tant hedge against other positions in the increase in the S&P 500 index 0.00 0.05 0.10
offs, (S&P 500: –6.15%, FTSE 100:
a portfolio, for example to hedge the (see table at bottom of facing page.) –8.57%, Nikkei –15.36% since 30
Annualised standard deviation
implicit short volatility position of a April), and both historical and implied
Source: Fimat
long/short equity manager. CHOICE OF EXPOSURE equity market volatilities have risen
From the correlation analysis The important question for the inves- dramatically over the same period
below, we can see that the correla- tor is how to best capture the ben- (VIX: 12.22% to 23.81%, S&P 500: 60 day historical volatility: 3.67% to
tion over the entire period since efits of a position in volatility; be it 10.47%, V2X: 11.98% to 26.69%). Credit spreads have also widened since
January 1990 is –0.65463, (see table through futures and options on the the beginning of May as shown by the iTraxx HiVol Index (33.09%, �15.23)
1, top right of facing page) indi- VIX index (or other indices); volatility and iTraxx Europe Index (26.41%, �7.19) In FX, implied volatilities rose to
cating that the VIX index tends to or variance swaps; or an investment their highest level in three years as the dollar weakened to near 12-month
increase when markets decline, it with a hedge fund trading volatil- lows versus the euro, GBP, and Swiss franc, though volatilities have fallen
is important to note, however, that ity. We will consider the period since back with the strengthening of the dollar over the last couple of weeks. The
the correlation during periods when January 2003, a difficult period for all FVAM consists of ABC Square Asset Management – Sigma Square, Estlander
the S&P 500 index was up is lower forms of volatility, and use the fol- & Ronnlund Global Volatility, KPG Investments – Asia Gamma Fund, Lynx
at –0.32629 meaning that volatility lowing proxies: Arbitrage Fund, SGAM Global Volatility Fund, Shooter Multi-Strategy Fund,
doesn’t decline proportionately to ■ Implied volatility: VIX Index Titan Global Volatility Fund and Turtle Fund. Figures are as at 14/06/2006.
FOOTNOTES AUTHOR: JAMES SKEGGS

1 Though Japanese equities have gone against this recent trend and have seen rising implied and historical volatilities James Skeggs is head
since last summer. of statistical reporting
2 The delta of an option is the ratio in change in price of the option with respect to the change in the price of the for Fimat’s Alternative
underlying security. Investment Solutions
3 In the case of equity options the shape of this skew is more like a slant, than a smile. (AIS) team in London.
Fimat AIS teams
REFERENCES offer a global range
of prime brokerage
Hull, J. Options, Futures, and Other Derivatives, 5th Edition, Prentice Hall (2003). activities on a wide
Jackson, M. Staunton, M. Advanced modeling in finance using Excel and VBA, John Wiley & Sons (2001) range of asset classes, including equities,
Hennessee Group, 2005. bonds, currencies, commodities, and their
Connolly, K. Buying and Selling Volatility, John Wiley & Sons (1996). related listed & OTC derivative products.
Calamos, N. Convertible Arbitrage Insights and Techniques for Successful Hedging, John Wiley & Sons (2003). The teams also provide dedicated
Demeterfi, K., Derman, E., Kamal, M., Zou, J., More than you ever wanted to know about volatility swaps (1999). account-management, cross-margining,
Habib, Dr R., Volatility Arbitrage – A New Hedge Fund Strategy, FX&MM. hedge fund start-up services, quantitative
‘Volatility Skew’, http://risk-glossary.com. information and capital-introductions
McMillan, L. ‘Trading the Volatility Skew in Options’, McMillan Analysis Corporation, http://www.optionstrategist.com. services.

FUND PROFILE : ACORN DERIVATIVES
From little acorns... a $900m business grows

Acorn Derivatives has garnered around $900m for its business on the reputation – and
performance – of its volatility arbitrage experts. David Walker investigated.
What is the history of your firm? Positions are continuously moni- ronment went significantly against to market-neutral so that if there
Acorn is now 16 years old. We started tored, and rebalanced as needed when our strategy. That served us well since is a significant move up or down,
Acorn to specialise in options strate- conditions warrant to maintain the our competitors – who were much it doesn’t cut significantly into the
gies which at that time were traditional market-neutrality of the portfolio. larger – didn’t have similar air-tight P&L. So we’re constantly rebalancing
call writing strategies for large corpo- risk-control procedures. to keep neutrality.
rate and public retirement funds. Over What is the focus of your firm? So, when the markets made strong Because of that, we are able to
the years, we’ve had as clients some of We only use S&P500 index call (July 2002) or erratic moves (Sep- avoid significant losses and capture
the largest corporate and public funds options in a combination of long and tember 2001), they weren’t able to deal significant profits when the market
in the country. short options with identical expira- with it. In our case, when we experi- stabilises. The ideal environment is
We have been an SEC-registered tions. Historically, we have managed enced losses, they were small losses. when implied volatility is at a high
investment adviser since our incep- option strategies on European and That continues to separate us from level and realized volatility is low.
tion. We launched our domestic fund Asian indices. Right now, the Europe our competition. A good example of this would be
in July 2001, and our offshore in and Asia markets have such a high From time to time, people come into the first quarter of 2003, in the days
December 2001. correlation with the US market that the market with a new idea or new leading into the invasion of Iraq.
We currently manage about $900m there is no real diversification benefit approach, people think it makes sense. During this time period, implied
in assets. About half of that is in to using those indices. Then a one-in-a-hundred-year event volatility averaged approximately
hedge funds and SMAs which use the When searching for additional upsets their thinking. It has been our 30%, while realised levels averaged
same strategy and the other half is markets, the key is to find another experience that one-in-a-hundred-year 22%, a spread of approximately 8%.
in overlay strategies that we are run- market that generates this same price events occur about every 10 years.
ning for corporate retirement plans discrepancy where the options are This is why we only use trade struc- What do you see as the risks of the
and one large state fund. generating implied volatility that’s tures with a pre-defined risk. strategy?
greater than the realised volatility All our clients have an opportunity The risks are strong directional moves,
Could you explain the philosophy of of the underlying instrument for a to have 100% transparency and we either up or down, which require fre-
your fund’s strategy? consistent period of time. Then you monitor the positions on an on-line quent rebalancing. A September 11
The fund focuses on the fact that have an opportunity to roll out our basis. Several of our clients look at 2001-type of situation where you have
index options generally sell at a high- strategy into that market. When the them every evening. a discontinuous market and can’t rebal-
er level of time premium than is environment changes and there is They are all listed and marked to ance because the markets aren’t open is
warranted based upon their historic some diversification benefit, we will market every night, so clients know another big risk.
volatility. This difference is captured start using them again. the prices they are looking at are
by simultaneously buying and selling current and accurate. Since all the How have you done in down equity
a four-piece unit of S&P 500 index Where does your firm’s competitive options we trade are listed, there is no markets?
options which, when combined, cre- edge lie? marked-to-market risk, as would be The market traded lower in two years
ate a market-neutral position. One main competitive edge derives found with OTC options or other less (2001 and 2002) since we launched
Specifically, the fund sells two from our initial client base (that is, liquid investments. our funds. We were profitable in both
options short at the current market large ERISA plans) which demanded We feel our 16-year history and over of those years. Since our launch, the
level and buys two options of the us to follow extremely tight and disci- 60 years of option-trading experience S&P500 index has traded lower in 23
same expiration, equidistant above plined risk-control techniques. add significant value. months and our option strategy was
and below the market. Those were embedded in every- positive in 20 of those 23 occurrences.
Because of the higher time pemium thing we did from the day we opened What are the ideal market conditions We feel that weak markets provide
in the options that are at-the-money, our doors. These risk-control tech- for your strategy? greater opportunity for us to add
the portfolio will benefit from the niques were designed to avoid peri- The key to our strategy is making value to our core option strategy.
time decay of the options. ods of significant loss when the envi- sure the positions are pretty close
So would you say you have low cor-
CORRELATION MATRIX relation to the market?
It does diversify a lot of different
Measure ADMC Ltd SPX GSCI CSFB Tremont CSFB Tremont CSFB Tremont types of investments. It is uncor-
Main Conv arbitrage Long/short equity related to the S&P, bond markets,
commodities, and most importantly
ADMC Ltd 1.00 -0.37 -0.01 -0.20 0.08 -0.26 other alternative investment strate-
gies. It is attractive as an addition to
SPX -- 1.00 -0.15 0.49 0.17 0.60 an existing portfolio because of its
non-correlated characteristics.
GSCI -- -- 1.00 0.21 0.05 0.16 We feel that a low correlation
is becoming extremely important
CS Main -- -- -- 1.00 0.62 0.95 as alpha generating portfolios are
being combined with passive beta
CS Conv arb -- -- -- -- 1.00 0.47 approaches to create portable-alpha
strategies.
CS L/S equity -- -- -- -- -- 1.00
What markets and instruments do
Note: Recent Merril Lynch study indicates large increase in hedge fund correlation to the S&P 500 index over the past five
you trade?
years. Data through May 2006.
We bundle together spreads of index
FUND PROFILE : ACORN DERIVATIVES
options to create a market-neutral where potential sources of volatility How does volatility affect your funds’ Years like 2001 and 2002, when the
position that have a short volatility could be developing. investment strategies? volatility was high and variable, are
exposure. We evaluate the factors within our As a general benchmark for implied among the best environments for
We often use a butterfly transac- investment process, then gauge their volatility, we use what most people our strategy.
tion. If the index is trading at 1000, influence and weight their impact. use – the VIX index which is dissem- Conversely, a market with a strong
to initiate a very basic combination, What we found, over time, was that inated by CBOE. Throughout most trend, such as in the final three quar-
we would buy one 950 strike call on these three factors tend to dominate of 2005, the VIX remained stable at ters of 2003, are among the most
the S&P500, sell two at-the-money volatility. a low level. difficult of environments, requiring
1000 strike calls and buy one out-of- If you go back to 1999-2000, it Recently, the VIX index has spiked constant rebalancing to keep up
the-money 1050 strike calls, all on the was mostly monetary conditions. higher and become more volatile as with the movements in the under-
same expiring month so there is no In 2001, it was mostly fundamental the safety net of global liquidity is lying index.
term-structure risk in the strategy at conditions. In 2002/early 2003, it was beginning to be reduced. Historically, When we’re in an environment
all. When we put it on, all four legs mostly technical conditions. through active management of the where we’re not making much money,
are in the front month or all four legs Since mid-2003, the cycle run portfolio, we have done well when we feel our investment process is not
are in the second month. It is prob- which had been 12-18 months, has the volatility of volatility is high. working 100% effectively. As a result,
ably the most conservative approach shortened significantly. From a trading perspective, we are we cut back the size of our positions
to arbitraging the inefficiencies in the It is unusual but it has happened also looking at implied volatility on significantly.
implied volatility of index options. in the past. the individual strikes and analysing So, if we’re in a low-return environ-
It caused us to shift our focus constituent effects on index volatility. ment, then our volatility of returns
How do you analyse the environment quite frequently and as a result, the Our strategy is based on the will probably be half of what it
in order to initiate a portfolio? returns have been disappointing condition that implied volatility is would be like in a higher-return envi-
Our focus is to identify and analyse because rather than looking at one greater than realised or historical ronment, such as 2001 and 2002.
sources of volatility. We have a disci- of the sources for six to 18 months volatility. That is the spread that In 2002, if we weren’t adhering
plined investment process which we as the market has traditionally done, we’re focused on. rigorously to strong risk-control pro-
continuously optimise. it tended to shift in the last year in As long as that spread is positive, cedures, it could have been a devas-
Each week, we go through 60 dif- increments of months, rather than our strategy can be profitable in all tating year.
ferent monetary, fundamental and years. It has made it very difficult to environments. We were presented with a lot of
technical factors trying to determine properly evaluate the impact. Despite the low levels of volatility opportunity because we avoided
witnessed in 2005, implied volatility the spikes in volatility and we really
BIOGRAPHIES: remained greater than realised vola- could take advantage of the enormous
William O Melvin Jr, president tility. Currently, the spread is about spreads that existed after the spike.
William O. Melvin, Jr. is responsible for the management of the option portfolios. He average, at 4%. The best environment was the
has more than 45 years’ experience in the investment business, beginning as a security One thing that could be affecting early 1990s. We were coming out of
analyst in 1960 with RW Pressprich. From 1962–1974, he was an institutional equity the environment now is the large per- the huge spike of volatility in 1987.
salesman and sales manager for FS Smithers. From 1974–1979, he was first an institu- centage of institutional dominance The institutional market place for
tional salesman, then fixed-income in the marketplace. options strategies hadn’t developed,
sales manager for Paine Webber. The percentage of program trading so we sort of had the marketplace
Melvin began his investment man- on the New York Stock Exchange as to ourselves.
agement career with Cigna Invest- a percent of total trading has risen That won’t happen again because
ment Management as a portfolio to 60%. There aren’t a lot of retail we have more participants in the
manager and director of marketing players, resulting in one hedge fund options market. Currently, with
in 1979. trading against another. the VIX index at higher levels, we
In 1982, he joined Bankers Trust believe the markets will be returning
William O Melvin (right), and Andrew Greeley Co. as the managing director of their Describe some good years and some to a more attractive environment for
investment management group bad years. our strategy.
where he began working with option strategies to improve clients’ risk/return results.
In 1985, he founded the institutional investment management unit of Kidder Pea- FUNDAMENTALS
body, Webster Capital Management, and developed a full range of risk control strate-
gies that focused on tactical asset allocation, portfolio insurance and options writing. Name of managers: Acorn Derivatives Management Corp
In 1989, he founded Acorn to specialise in using equity index, fixed income and Full name of funds: ADMC Absolute Return Strategies LP
international equity index options to enhance client returns. ADMC Absolute Return Strategies Offshore Ltd
He has also functioned in the futures market as Acorn is a CTA. Melvin studied civil Address of manager: 50 Main Street, White Plains, NY, 10606, USA
engineering at Brown University, and after service in the US army as a missile specialist, Phone contact: +1 914 949 3516
studied business and finance at New York University. He is Treasurer of the Donald R. Launch date of fund: 1/07/01 (ADMC LP) 1/12/01 (ADMC Ltd)
Reed Speech and Hearing Center, a member of the Board of directors, and Chairman of Firm assets: $900m
the finance committee of the Phelps Memorial Hospital and Kendal-on-Hudson Target annualised volatility: 8%-12%
Prime broker: UBS Securities LLC
Andrew Greeley, CFA, vice- president Auditor: Ernst & Young
Andrew Greeley is responsible for the management of the option portfolios. He also Management fee: 1%
oversees trading activities. In 1992 he worked at Tradition UK, in London, where he was Performance fee: 20%
a junior trader. In 1993 he worked on the floor of the Chicago Board Options Exchange. Domicile: New York (onshore LP),
In 1994 Greeley joined Acorn to assist in broadening its option strategies. Cayman Islands (offshore Ltd)
He is a member of the Market Technicians Association and a third-level Chartered Share classes/currencies: US$
Market Technician (CMT) candidate. Greeley achieved his MBA in finance from the New Minimum investment: $1m
York University Stern School of Business and a BS from New Hampshire College. Liquidity: Monthly, 45 days’ notice

FUND PROFILE – SIGMA SQUARE
Sigma Square – making money on b

Sigma Square has not needed trending as fixed income, currencies or com-
modities. A further step for us could
security moves. A skew position is
a long/short position on volatility
volatility to provide its investors with probably be the set-up of investment instruments such as options having
vehicles dedicated to each market the same maturity but with different
healthy returns of 4.80% in 2006 to 31 region and underlying. strikes. The most basic skew strate-
May, the firm tells David Walker Could you explain the specific strat-
gies are puts or calls spreads.
egies, starting with dispersion And theta arbitrage?

Could you explain the philosophy You note you have a minimum 80% In very simple terms, a disper- The theta is the effect of the time on
of your fund’s strategy? in volatility-based strategies and sion trade is a bet on how different an option and represents the small
Sigma Square treats volatility as an 20% maximum in delta-based. Why the evolution of an index will be fraction of its price the option loses
asset class, which means the fund is this, and could you explain the dif- compared to its components. It is every day toward its maturity, eve-
does not have a systematic long bias. ference between the two? effectively a correlation position. rything else being equal. Sometimes,
Directional views can be taken Volatility strategies are not exposed A dispersion strategy, by usually the market presents you with theta
on the volatility itself but our to market direction and therefore being long volatility on the indi- arbitrage opportunities or oppor-
approach also combines strategies have little correlation to equity vidual components and short the tunities to collect the theta rather
that are not exposed to the absolute market returns. They are exposed to index volatility, provides returns than paying it, especially over long
level of the volatility (for example, market movements instead. when stocks are uncorrelated and periods of market breaks like week-
spread positions or arbitrage of the This is the core business of the move on large scales but in opposite ends or holidays.
volatility surface). fund and represents 80%-100% of directions, that is, with an overall
However, the convexity of the our value-at-risk (VaR) limits. offsetting effect that leaves the index What does your firm’s competitive
portfolio ensures it captures returns However, because options trading close to unchanged. You are, there- ‘edge’ lie?
on large market movements. In effect, implies a lot of research on the fore, capturing all the movements on We have developed in-house propri-
Sigma Square is an absolute-return underlying (via fundamentals, the stocks while not paying away too etary software that helps detect and
fund that can provide insurance in technical or graphical analysis), much on the index. So it is a relative- analyse trading opportunities in all
case of dramatic movements. we wanted to have a separated and value trade and, in theory, doesn’t the strategies explained above.
The aim was to adapt into the limited exposure to market direc- have a great exposure to pure vola- This tool is completely tailored to
hedge fund world a successful tions, to be able to take advantage tility direction. our needs and we can easily evolve
strategy that has generated con- of this research. There is also it over time to suit the demands of
stant and large returns over the an evident synergy between the And volatility-spread positions? our managers.
years for investment banks. two activities as a delta approach Again, this is a relative-value trade, It allows us to have a systematic
enhances options’ gamma hedging, consisting of a bet on the volatility approach to these strategies with
MONTHLY RETURN DISPERSION for example, and, on the other hand, spread between two securities. a constant monitoring system on
3 options offer very interesting ratio The basics are similar to a long/ these aspects of the market. On a
for pure directional trades because short equity position, for example, daily basis, the software automati-
Number of months
of their leverage. This is especially as you are playing the outperform- cally scans our whole trading uni-
2 the case when volatility is low as it ance of one against another. The verse then ranks and highlights the
makes premium even cheaper and difference is that the performance best opportunities it has detected.
provides a comfortable risk manage- is measured on the volatility rather However, we do not rely purely
ment and a natural stop-loss. than on the price. As for an equity on these statistical facts and apply a
1
spread position, one can use econo- second filter by checking the funda-
What markets and instruments do metrical and statistical techniques mentals, for instance, and using our
you trade? (for example, mean reversion), to try market expertise that may provide an
0
We focus mainly on derivatives to assess better the attractiveness of explanation as to why something is
-3 -2 -1 0 1 2 on European equities and indices, these trades. suddenly trading ‘out of way’.
Upper bound for monthly returns (%) although we are trading opportunis- Therefore, the experience of our
Source: ABC Square AM LLP tically in the US and in Asia, as well And calendar positions? managers, who have more than 10
A calendar position is a long/short years’ experience each in equity
position in volatility terms, through derivatives trading, is also an impor-
ALAIN BUENOS – PARTNER AND CEO derivatives that have different matu- tant factor.
Alain Buenos has 10 years’ experience in equity derivatives rities. They can be useful if one One could also observe that the
trading. From 1998-2003, he was at Commerzbank London wants to play in isolation a specific current situation in terms of vola-
where he developed the pan-European equity derivatives event in time (for example company tility, although extreme, is not so
trading desk and became deputy head of European equity earnings, takeover announcements dissimilar to Japan in the 1990s.
derivatives trading. In addition to risk managing 10 propri- and so forth) and the consequences It is interesting to point out that
etary traders, he was one of the main market participants in it can have on the company’s shares most of our managers were actually
France, Spain and Italy. From 1997 to 1998 he was at Com- during a certain period, without working there at that time. But they
merz Financial Products in Paris where he was an equity taking the outright volatility risk. have also seen the extremely volatile
derivative proprietary trader. environment in Europe in the years
From 1993-1997 he worked for Société Générale in Paris where he traded all Skew positions? 1998-2002.
the main European equity derivatives markets, and in Tokyo where he traded the The skew is the name given to the When it comes to our invest-
Nikkei extensively. Alain Buenos graduated from Ecole Centrale de Lyon, one of implied volatility curve when going ment procedure, we have a global
the leading Engineering Schools in France. He also holds a Master in International from strike to strike on a same matu- approach as volatility on a stock
Finance from H.E.C.(Hautes Etudes Commerciales). rity. It translates the market antici- can be affected by external factors
pations in terms of volatility as the beyond just share price movement.

FUND PROFILE – SIGMA SQUARE
both sides of volatility’s golden coin

The impact of structured products the carry of the position, until its (Obviously, if a trade doesn’t look could get crushed in the future.
emission or redemptions, or the effect maturity, will provide the return via attractive anymore, it can be closed
that other markets can have needs to daily gamma management. before it reaches its stop-losses.) Could you explain how much of the
be taken into account when trading At the portfolio level, we have a fund’s returns have come from short
volatility. For example, credit default What turnover do you have? maximum acceptable drawdown set volatility trading?
swaps (CDS) can offer attractive We have a rather fast turnover for at 3% on net asset value per month, Some of our strategies are based
returns but, at the same time, they can an option strategy but the timeframe where the portfolio has either to on relative value (volatility pairs or
present you with a bankruptcy risk on of a trade can vary from a couple be liquidated or at least complete dispersion), so there is always by
a given company. Therefore, people of days to a couple of months. On gamma immunisation can alterna- definition a short leg. In the current
would be prepared to pay more for average, a position is kept for four tively be considered should we be in environment, outright short vola-
downside protection, reshaping weeks. Trading options also requires a fast market position, which does tility is, however, not negligible as
the skew structure in the process. you to re-hedge your position theo- not always allow a quick exit. over the last few years, volatility has
So, this impact is an ‘import’ from retically daily, although some people We also have tailored stress sce- gone more down than up.
another market and not necessarily prefer shorter or longer horizons. narios to cover overnight gap risk, Because we are not long-only and
justified by the price movement. The like our “seven-square” scenario because we are looking at the vola-
combination of these factors allows Are there liquidity issues you must be where the whole portfolio is stretched tility curve as a whole, we can actu-
us to have a high-quality judgement mindful of, and how does ABC Square with a 7% fall on the equities market ally have a range of strategies with
on the implied volatility. Asset Management’s trading model and a 7% hike on volatility. locally opposite directions.
take these issues into account? The resulting return has to be Overall, probably some 30% is
Could you provide a case study of Liquidity is paramount in our risk within the 3% loss that is explained attributable, one way or the other, to
where you have made money? management and, de facto, has an above and the portfolio long vega at a short position.
Trades we are doing frequently at impact on our trading universe. these levels.
the moment are implied volatility We focus on blue chips or major Overall, although we allow our- PERFORMANCE
pairs, using one of the functionali- indices and on short-term maturi- selves to be locally short volatility, the
ties of our software. ties (of less than one year) as this general idea is to ensure we have long 104
As explained, our model, being fed is where you will find highly liquid tails that will capture returns on large
Class A $
with data daily, provides a ranking listed options. This is to ensure we market movements. 103
of volatility pairs, based on con- have no liquidity problems to keep
straints imposed by the managers; our ability to switch quickly from How many positions do you typically 102
for example, sectors, countries or one position to another and to adapt have at any one time, and what’s the
101
clusters filter. The most attractive instantly to a changing environ- maximum and minimum?
ones are usually pairs where implied ment. As a matter of fact, we have We have a diversification criteria 100
volatility is trading at least two set up the hard close of the fund to where, at any given time, the port-
standard deviations away from the be at $300m. folio has a minimum of 15 open posi- 99
historic volatility mean. tions. We do not set any maximum
98
We then proceed with fundamen- What risk-control policies are in numbers.
tals and graphical analysis checks place, including stop-losses? 2005 2006
to confirm the results of the model We have several levels of risk con- What are the ideal market condi- Jan 05 - May 06. Source: ABC Square AM LLP
before putting the trade on. trol. The first is at the position level, tions for your strategy
From then on, there are two ways where each trade is monitored in and what is the greatest
to capture the profit from this trade. accordance with the pre-defined threat it faces in making FUNDAMENTALS
Either the market realises that this target gain. Intermediary and defini- money?
spread has been trading out of its tive stop-losses are set up as a per- The speed of change of Investment advisor: ABC Square AM LLP
normal range and then reverts it centage of the target gain and with the volatility (or ‘volatility Full name of fund: Sigma Square Ltd
closer to its usual levels (in which precise exit procedures in each case, of the volatility’) is an Address of manager: 5 Ludgate Hill,
case, the profit will appear in the should they be reached. This is first important factor as it will London EC4M 7AA
mark-to-market of the position), or to ensure a positive gain/loss ratio. create more opportunities United Kingdom
for our style of trading. Phone contact: +44 (0)20 7248 0020
A trending market with Launch date: 1 February 2005
PENG TANG – PARTNER AND COO no specific company or Target annualised return: 10%-12%
Peng Tang has eight years’ experience in index and statistical arbitrage trading. economical news, on the Target volatility: 5%-8%
From 1998-2004, he was at Commerzbank Securities London, where he built other hand, could provide Prime broker: Fimat, Citigroup
up statistical trading and enhanced index arbitrage in less ground for volatility
Auditor: Pricewaterhouse-
Europe and the US alongside the index arbitrage business, directional plays. This
and integrated both into the newly-created Global Arbitrage kind of environment usu-
Coopers
Group. Peng was global head of the business and man- ally takes away a lot of Annual fee: 2%
aged a team of up to 11 individuals ranging from traders to interest and liquidity from Performance fee: 20% (with
quantitative and IT developers, based in New York, London, the market and arbitrage watermark)
Tokyo and Frankfurt. From July 1996 to July 1998, he was opportunities tend to dry Listing/domicile: Dublin/Cayman Isles
at Dynabourse in Paris and Dyna Option in Frankfurt (which out. If this is happening Share classes/currencies: Euro, USD
is now part of Calyon Group). Peng Tang graduated from after a hectic period where Minimum investment: $/€1m
University of Paris I Panthéon Sorbonne and he holds a DEA (Diplôme d’Etudes absolute levels of vola- Redemption terms: Monthly
Appliquées: Post Graduate Studies) in Monnaie-Finance-Banque, a ‘Magistère tility have reached impor- Please note: 2006 return to 31 May in
d’Economie’, and an MSc degree in Econometrics. tant levels, one could still introduction paragraph is estimated.
play the fact that volatility

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RESEARCH AND DEVELOPMENT
Keeping pace: the R&D imperative

there was a structural change in the “As we are focusing mainly on
US markets. Specifically before this plain vanilla options, the nature of
point in time, there would be general the instruments we trade does not
agreement among option traders that change as per se, but we make sure
volatility would spike higher on some we take into account impacts and dis-
event, but then would trend lower over tortions generated on the volatility
a period of time as the market normal- behavior by structured products.”
ised,” he adds.
“One did not see volatility collapse NEW INSTRUMENTS
over a very short period of time. Further afield again, the leading
Beginning in April/May 2001 this volatility arbitrage managers are
changed, in that we started seeing also looking keen-eyed at new instru-
volatility gap lower as frequently as ments and markets to which their
gapping higher. models can profitably be applied.
“This sea change made trading a Shooter Fund Management, for
long volatility book, in our opinion, example, says the firm is “ very
not a compelling strategy. I think its excited about commodity strate-
taken some of our colleagues who gies for the fund” in the future,
trade a bit of time to come around to actively pursuing the addition of
our view, however I think those that this to the portfolio.
were able to stay in business during Do specific markets require more
2002-2004 would agree.” intensive R&D to tackle successfully?
Martin Estlander thinks not as a gen-
WHEN TO CHANGE? eral rule, but notes occasionally extra
Estlander adds it makes sense to attention needs to be paid to specific
consider modifying or updating a niches: “There are certainly markets
system, as it could prove profitable that attend more focus from time to
to do so, in “changing environments time,” he explains.
Sit back, relax... and you’re relegated to and structural breaks. This can, for “If the crude oil rallies, you will
the also-rans at best, to history more example, be volatility levels on dif-
ferent time horizons, central bank
have a lot of investors and traders
focusing on the price level and this
likely, when it comes to volatility arbitrage, policy (and) volatility skews.” will naturally have an increased
However, he adds change should impact on other markets as well.
leading traders tell David Walker not be made for change’s sake alone: “In terms of the volatility arbi-
If you don’t evolve your system and “If you look at the volatility “We aim at updating systems as it trage strategies that we run, you
trading approach in volatility arbi- behavior over the past few years,” he becomes necessary but also to leave need a liquid enough option market
trage, two things can happen. adds, “you would realise that we have systems unchanged when there is and therefore financials instruments
Your competitors will branch into been through some extreme levels, a good reason for that. It should be play a central role. ABC Square
new instruments and markets, leaving from the very high levels in the year emphasised our strategy is very AM’s Peng Tang adds, “the method-
you with lagging returns. Or the mar- 1998-2002 to the rock bottom situ- long-term oriented. For example, our ology (of R&D) is pretty much the
kets you trade in may change, leaving ation up until the start of 2006. So, Global Markets program has been same for every market, as we would
your program less robust to deal with although the pricing part of the model run successfully now for 15 years.” analyse flows and fundamentals
shocks. A third thing then would pre- does not require important changes, Russell Abrams concurs volatility and compare historical volatility to
sumably also happen – redemptions. fine tuning is necessary to ensure the arbitrage can be a case of the adap- implied volatility.
The leading volatility arbitrage data sample is homogeneous.” tive, and the dead: “history’s shown in “However,” Tang says, “each
managers concur ‘constant improve- Estlander notes the underlying pretty much every area that nothing market may be different as data gath-
ment’ is rarely more relevant than in markets can undergo sufficiently left static is effective over time. Trading ering for instance could be more dif-
volatility arbitrage. seismic changes – where the assump- systems and methodology are no difficult on some occasions than others,
Martin Estlander, chief execu- tions that have underpinned vola- ferent. The times and markets change with liquidity playing a substantial
tive officer of Finland’s Estlander & tility arbitrage’s ranks are sufficiently and evolve, and one has to as well.” role in order to have enough signifi-
Ronnlund notes simply: “a manager’s shaken – to catch out those not cant information for research and
edge consists of being able to operate, investing enough in innovation. DANGER LURKING development. Given our trading style,
update and refine the programs so “One example is the stock crash However, volatility arbitrage managers highly liquid options are a condition
that they are able to extract what in October 1987 when the skew in will also need to conduct broadly- to any trading taking place, together
they are meant to extract in changing implied volatilities prior to the crash based R&D, keeping lookout for other, with affordable trading costs on both
market conditions.” were less distinct,” he notes. “After the developing areas of the capital mar- the derivatives and the underlying.”
Peng Tang, partner and COO at crash, out-of-the money put options kets whose growth may impact their Titan’s Abrams believes R&D,
ABC Square AM, adds, while broad have been priced at higher implied own portfolios and models. and a committed focus on whichever
fundamental underpinning’s of a volatilities than at-the-money options. Tang continues: “There is a con- market one trades, is so paramount
system may remain constant (“our This is one example of changing stant product innovation on what to volatility arbitrage as a hedge
model aims to adapt to market con- conditions that a volatility arbitrage we call ‘exotic’ instruments that may fund strategy, that the “intensive
ditions by analysing market move- program needs to consider.” Portfolio have an impact on volatility levels. concentration” required is “the prin-
ments and flows”), there always manager at Titan Capital Group Rus- These products are designed and sold cipal reason Titan Capital Group
remains “a certain amount of fine sell Abrams adds another, US example by large investment banks to retail is a single-strategy shop and only
tuning involved. to Estlander’s. “In April/May 2001, and institutional investors. trades volatility.”

PROFILE : S HOOTER FUND MANAGEMENT
Multiplying
the sources of
healthy return
David Beddington at Shooter Fund Manage-
ment explains to David Walker the firm’s
Shooter Multi-Strategy Fund has few days
when all positions in all its books profit.
However its diversification policy conscious-
ly aims to produce the best times for some What do your calculations show
volatility arbitrage’s correlation to
diversification of returns. You need
to be careful that diversification
positions precisely when markets are dif- the traditional asset classes/other adds value and doesn’t water down
hedge funds has been historically? profits unnecessarily. We diversify
ficult for others. Volatility trading styles are so flex- across asset classes to broaden our
ible that it is important to focus on opportunities and increase our long
What do you see as the case for classes have recently shown an the strategy and not just the asset term alpha.
trading volatility and why is this increased correlation of returns. class. Our trading style has his- We run each asset class as a sepa-
case sustainable? Vanilla and exchange option torically been uncorrelated to tra- rate book with a diversification of
Volatility can be traded as an asset markets have very high levels of ditional asset classes, particularly strategies within each asset class.
class. This is a valuable diversifi- liquidity with a wide range of par- during periods of market stress, Some positions we implement
cation, particularly as more main- ticipants (unlike convertible bond which is when a lack of correlation are long-term and expected to
stream trading strategies and asset markets.) The range of participants within a portfolio matters. produce sizeable returns during
ensures a diversity of interests periods when our more regular rela-
SHOOTER FM RISK/RETURN which allows traders to participate What is the experience of the team tive value positions will potentially
in a healthy market environment. on the fund? experience volatility.
PROFILE
Volatility markets are not a zero- The principal, Mark Shooter, was a The best days for some of our
25 sum game, unlike futures, which qualified actuary who traded vola- trades are designed to coincide with
Annualised return (%)
SFM US$ CTAs use. tility at SBC O’Connor during the difficult market environments for
20 Share Class
Volatility markets have partici- 1990s before starting his own pro- other positions. We rarely have days
15 CSFB/ pants that are looking to hedge and prietary trading firm. when all strategies in all books gen-
Tremont buy insurance, take directional expo- The rest of the team has a range erate profits.
HFI
10 sure to the underlying asset class of experience from trading vola- However, we have a very con-
S&P 500 Index for profit, trade directional volatility tility in banks and hedge funds. We sistent daily, weekly and monthly
5
(short and long) relative value, arbi- have a number of PhDs on staff net performance due to the mixture
0 Fimat FVAM trage, macro, technical and funda- who contribute to our quantitative and balancing of these positions.
mental positions. This makes them research team. This is our multi-strategy approach
-5 one of the most dynamic asset to volatility trading.
0 1 2 3 4 5 6 7 8 classes to trade with a wide range Could you explain the philosophy
Annualised volatility (%) of opportunities present to a team behind the fund’s allocation between Your fund trades both ‘equity vola-
with the appropriate skill set. different markets? tility relative value’ and ‘equity
Source: Shooter FM
We diversify across a range of put protection strategy’. Could you
asset classes in order to broaden explain these terms?
SHOOTER FUND MANAGEMENT our opportunity set. As an abso- We have the majority of our risk in
lute return fund we never have the relative value trades that are broadly
excuse of blaming market action (or market neutral.
lack of action) for a disappointing As a volatility trading firm we nat-
return. So we focus on a range of urally run a delta-neutral book using
asset classes and a range of uncor- futures to hedge this exposure. So our
related strategies. relative value trading is more focused
on the options risk.
Could you give some idea on how Our core relative value positions
the opportunities in different mar- leave us broadly neutral on a net
kets correlate in time (or not) and basis when considering gamma,
how diversification can aid a total vega and theta. Additionally we buy
portfolio? downside puts to provide sizeable
The reason diversification is impor- returns during periods of increased
L-R: Ari Andricopoulos, Charles Phan, David Beddington, John Goodridge, Mark Shooter, Stefan Boor
tant is, diversification of risk means volatility.

PROFILE : S HOOTER FUND MANAGERMENT
markets. Therefore our strategies ardised settlement market to held by many is reflected in other
are sustainable in a range of eco- develop. Companies like swapswire areas such as the high level of new
nomic conditions. are leading the way. There is no assets committed to emerging mar-
That said, as traders, we need reason why these products can’t kets in the fourth quarter of 2005
movement in the market, a sus- be exchange-traded as well. The and first quarter of 2006. Increas-
tained higher volatility environment resulting advantage for counter- ingly the risk being taken to gen-
by definition would provide this party credit risk, market transpar- erate a decreasing rate of return
and increase trading opportunities. ency and liquidity will be a boon to will prove a challenge to some of
Higher interest rates have histori- all market participants on the buy- the current market trends.
cally been associated with periods and sell-side. But again, this may
of increased volatility. not occur soon. What risk management tools/tech-
niques do you employ?
What other diversification is You made 4.83% in April 2005. We run a range of stress tests and
important to the strategy? What went right? value-at-risk (VaR) models on the
We are short cycle traders with In a word – puts. We had some portfolio.
an aggressive trading style. Our skew positions that produced a
average position lasts for approxi- very high payout during the sell- You focus on front-month, more
mately four weeks. We trade in off in mid April. The cash market liquid contracts. Are there also
option expiry contracts that have lost 4% in three days, which was opportunities further out?
high liquidity. To achieve this we beneficial to our positions. We prefer to trade in liquid and
limit our trading to options within transparent markets. The structure
the front two years to expiry. There was a minor drawdown of long-term volatility markets
(1.33%) in October 2005. Why? makes them less attractive for us at
We made about 5% in April of Does your strategy rely on market This was the only monthly loss for this point.
2005 when many other hedge funds turbulence, or high volatility? the fund since inception. We had,
faltered. As a fund we generate our Our relative value strategies are arguably, a reasonable but not excel- Indices can be traded in volatility
alpha from relative value trading not dependent on a high volatility lent position and we suffered a mark- arbitrage, but can volatility arbitrage
however we do tend to pay a small environment. This is shown by the to-market loss due to temporarily be sensibly applied to single names?
amount of decay monthly and hold strong performance of the equity adverse conditions. Of course, there is a healthy market
a long out-of-the-money put posi- book over 2005 when volatility This will inevitably occur from in a range of single-stock options.
tion which leaves us with a long levels hit 20-year lows. time to time. As the fundamentals These can be traded through an
volatility exposure after a large We have strategies that histori- of the trade were still justified we arbitrage approach, statistically,
move in the futures market. cally perform well in high as well maintained the bias of the posi- fundamentally and a range of
as in low volatility environments. tion over October and November, other strategies.
Could you give some flavour as Our put protection will naturally regaining much of the lost ground. The higher volatility levels in
to how the different markets have perform in a higher volatility envi- Our long put position did not single names can present opportu-
contributed to the fund returns in ronment, particularly during the perform in October due to the flat- nities for those with an information
different economic conditions? transition movement. tening of skew (the premium puts advantage and an efficient execu-
We seek to take advantage of any carry against calls of the same tion and position management
inter-correlation in market move- We have noted convertible managers delta) that occurred in October. system. There are inherent risks
ments. By trading in a range of asset moving into volatility arbitrage This was a trend that persisted in building too large a holding in
classes, we increase our informa- last year. Is there a danger of over- consistently over the second half the outstanding interest but it is no
tion flow from financial markets. So crowding and diminishing returns? of 2005 and is reflective of the different from an equity long/short
while a particular market movement ‘Volatility arbitrage’ is a term, quest for yield in a world of low strategy, which may encounter
may not benefit one book we may be similar to the term ‘hedge funds,’ numbers. similar issues.
able to capitalise on it elsewhere in that is used to describe a very wide The risk premium of downside A conservative approach to
the fund. range of trading styles. protection in equity markets was writing single stock options (if there
However, our strategies them- We are very close to our markets eroded as the market built a geared is one!) would require a deep funda-
selves are not dependant on under- and do not believe that any new long position heading into 2006. mental as well as statistical under-
lying market conditions. We are entrants such as convertible man- This aggressive trading stance standing of the target company.
tactically and not structurally con- agers are crowding our trades.
cerned with the direction of move- FUNDAMENTAL FACTS
ment, whether in volatility or cash What instruments and markets for
trading do you see as opening up in Manager’s name: Shooter Fund Management LLP
the future to aid the strategy gener- Full name of fund: Shooter Multi-Strategy Fund Ltd
FUND RETURNS ON $1000 ally, or your fund specifically? Address of manager: Unit 206, Business Design Centre,
1,300 We are very excited about com- 52 Upper St, London N1 0QH
SFM US$ Share Class modity strategies for the fund. We Launch date: November 2004
CSFB/Tremont HFI are working toward adding this as Size of portfolio: $500m
S&P 500 Index
1,200 a fourth asset class. Target annualised return: 15%-18%
Given the huge increase in Average annualised rtn: 19.61% (as at 01/04/06)
exchange contract volume in Europe Target (& actual) annualised volatility: 8 (4.4)
1,100 with the advent of electronic markets Administrator: JP Morgan Tranaut
it would be great to see a commit- Prime broker: Deutsche Bank
ment from United States exchanges
1,000 Fimat, Lehman
to adopt a modern business model
Annual/performance fee: 2% / 20%
and embrace screen-based trading.
However, due to vested interests this Listing/domicile: Dublin/Bermuda
900
may not occur soon. Share classes/currencies: Euro, dollar
04 2005 2006 There is also the potential in Minimum investment: $1m
Source: Shooter FM SWAP markets for a more stand- Envisioned capacity: $800m target (for Dec 2006)

TRADING RATIONALE
Traders’ toolkit:
SHORT RATIO PUT SPREAD SHORT RATIO CALL SPREAD
options pay-offs
Volatility arbitrage is not just about know-
ing the instruments and trading strategies
– as James Skeggs from Fimat explains, an Short 1 put and long 2 puts at a differ- Short 1 call and long 2 calls at a dif-
understanding of various option payoff ent strike on the same underlying ferent strike on the same underlying
possibilities, and what trades work best The rationale an idea about which direction he expects
in given environments from a return and The trader feels that options are relatively
inexpensive and expects that the market
the market to move in, but doesn’t want
to participate if the market goes in the
price perspective is also crucial. will move sharply. other direction. These strategies are
In addition, he has also noticed that cheaper to implement than the straddle
OTM options have a lower skew. He has or strangle positions to the left.
BASIC TOOLS
LONG CALL OPTION LONG PUT OPTION SHORT VOLATILITY POSITION
SHORT STRADDLE LONG RATIO CALL SPREAD
LONG VOLATILITY POSITIONS

The rationale options are highly skewed. The trader is
LONG STRADDLE LONG STRANGLE The trader feels that options are over- aiming to capture the time decay (theta) of
priced, that is, implied volatility is high, and the options. With a long ratio call spread,
expects prices to remain fairly constant in the trader is looking to protect himself
the future. He also notices that the OTM should the market move down sharply.
LONG BUTTERFLY LONG CONDOR
Long 1 call and 1 put on the same Long 1 call and 1 put on the same
underlying at the same strike underlying at different strikes
The rationale will allow the trader to profit, although

The trader here feels that options are while the strangle position will be
relatively inexpensive and he expects cheaper for the trader to implement (this The rationale the market move sharply in either direc-
the market will move sharply, but the because the strikes are further away from The trader feels options are overpriced tion. The trader is aiming to capture the
trader does not have a clear idea in the underlying), larger price movements (that is, implied volatility is high) and options’ time decay (theta). A condor posi-
which direction the market will move. will be required by the trader to make the expects prices to stay fairly constant in the tion is cheaper to implement but leaves
Both of these positions directly above single position profitable. future, though wants to cap losses should some of the potential profits on the table.

P ORTFOLIO C ONSTRUCTION
Stop loss: how volatility arbitrage

can act as portfolio insurance
TRACKING ERROR – ARE VIX AND VDAX GOOD PROXIES?
Volatility arbitrage should diversify risk, not Fund of funds managers may be tempted to see the best-known volatility
simply aggregate it, but how are allocators benchmarks – the Chicago Board of Option Exchange (CBoE) VIX Index and
to assess which managers will help do the related VDax, off Germany’s DAX Index – as simple and quite accurate proxies
for market volatility, and hence the size of opportunity sets for volatility arbitrage
former? David Walker went in search of managers. But are they?
One volatility arbitrage manager Hedge Funds Review spoke to about the
some answers... appropriateness of volatility benchmarks answered simply: “At present I don’t
know of any good benchmarks.”
Volatility is meant to be friendly to tunities for trading single-name GAM’s Jennifer Drake believes the the Vix and the VDax volatility indices
hedge funds, so it is little wonder options are limited. are “bad proxies” for opportunties in the strategy as a whole, and one man-
funds of hedge funds are increas- Coupled with their higher trans- ager noted while “these would be good benchmarks for directional volatility
ingly using volatility arbitrage action costs and lack of scalability, players they would not be for arbitragers.”
funds to provide a cushion to more they typically make smaller funds, However, she adds, such broad benchmarks could be regarded in a similar
‘traditional’ hedge fund strategies whose assets rarely exceed $100m, light to credit spreads – “The higher they are the better the opportunities.”
in choppy markets. she says. The most oft-used benchmarks “can give an approximate view of the mar-
Arbitrage strategies typically do The liquidity providers, which ket,” she says, “but might be misleading, as the opportunity-set for volatility
not fit into the GAM philosophy – thrive on inefficiency but do not managers is much bigger than the indexes imply.”
the firm prefers investments in what require high liquidity, do well in To an extent Drake’s sceptical view is shared by Martin Estlander, CEO
it regards as more scaleable Asia, by way of contrast, of Estlander & Ronnlund. He adds that the accuracy and relevance of the
strategies – however, Jennifer she notes. VIX/Vdax benchmarks “depends on what kind of volatility
Drake, manager of GAM’s They are limited to elec- arbitrage program one is running.
Multi-Arbitrage Hedge Fund tronic markets, found in “If one only focuses on equities then VIX might be a
says volatility-based strate- Asia, as well as those in good benchmark, but if one has a bigger trading universe
gies remain worth investing the United States and in the then of course one also needs a wider benchmark,” he
in, nevertheless. United Kingdom. says. “The relevant benchmark can only be determined
She says many investors Increasingly, volatility when the investment strategy is known.”
view volatility as a type of funds have taken on a Drake notes that much of the opportunity for the strategy
“portfolio insurance,” and Jennifer Drake, diversified mandate, she Martin Estlander,
is governed more by dispersion – or the ‘volatility of volatil-
allocations are made with GAM says, becoming volatility- Estlander & Ronnlund ity’ (the volatility within an index) – than by the volatility
this firmly in mind. orientated shops, playing displayed by the index itself. Thus, if volatility increases, but
As many traditional market the convertibles markets as well as all moves uniformly in the same direction, the opportunity for managers has
shocks in the past have shown, hedge volatility, and GAM’s fund has its actually reduced, Drake says.
fund strategies can often share factor largest volatility allocation to funds So if simply looking at a broad volatility benchmark is insufficient to gauge the
exposures common to different mar- that trade both strategies. strategy’s opportunity set, and if Fimat’s FVAMtm is viewed as a good starting
kets, leading the ‘alternative’ portion “It’s a natural evolution of the point for conducting top-down due diligence, before further investigation of spe-
of what a manager believes to be a strategy,” she says, utilising both cific single managers, what are the sine qua non questions allocators should put
well-diversified portfolio to correlate probability-weighted views on the to a volatility arbitrage manager during their rigorous assessment?
at just the wrong time. movements of the underlying asset, Estlander & Ronnlund’s Martin Estlander notes assessing a manager’s edge
Using volatility arbitrage to just using different instruments. – and its sustainability – is not necessarily that different to assessing other strat-
cushion a portfolio in these high Volatility managers do tend egies. “As with any manager it is important to understand what he is doing and
stress moments is a strategy advo- to share a quantitative mentality whether it seems to be likely he will perform in the future,” Estlander explains.
cated by many of the volatility arbi- driven by probability and deriva- He adds allocators can discover whether a manager can still generate
trage managers themselves. tives, “a very upside-downside men- profits in low-volatility climates by “seeking to understanding the manager’s
Drake notes there are numerous tality,” Drake says. program and its characteristics in different environments.”
ways to play volatility arbitrage, each “They might be more conservative, Portfolio manager at Titan Capital Group, Russell Abrams
variation displaying different char- by nature, than a typical equity long/ adds: “I would suggest back-testing their returns in your
acteristics, and each likely to make short manager, for example.” portfolio and seeing whether they add value, or just add
money in different markets. Within this group, however, and risk. Also I would look at their ability to make money dur-
Volatility managers must consider as with any strategy, there are man- ing 2002-2005 as those have been incredibly difficult years
the trade-off to be made in different agers with very different attitudes for the strategy.
markets between liquidity and inef- towards risk, which provides a spec- “I would also ask for exposure transparency,” Abrams
ficiency, she says, both of which are trum of possible fund characteris- Russell Abrams, says, “in other words have them provide market scenarios
desirable but inversely correlated. tics and risk-return profiles. Titan Capital Group and how their book will perform, this should be very easy
Where a manager trades in rela- GAM allocates between 15%- for a good portfolio manager.”
tion to these factors dictates the type 30% to volatility and convertible He adds, as a pointer for what prospective allocators might look for in an
of fund it is, she adds. arbitrage funds. Drake says, while underlying volatility arbitrage hedge fund manager, “we believe our edge is
The relative value, equity option the strategy has had difficult times not identifying good trades, but combining them into a portfolio. What matters
traders are limited in which mar- in recent years, and although it has is what one loses the 30% of the time you are wrong, and are your positions
kets they can trade by liquidity picked up somewhat in 2006, it has aggregating risk or diversifying it?”
constraints, Drake says, and are less still lagged some of the more direc- Select the right manager and the answer should be very much the latter.
often found in Asia, where oppor- tional strategies.
www.hedgefundsreview.com July 2006 | VOLATILITY ARBITRAGE REPORT | 19

FUND PROFILE : SGAM AI G LOBAL V OLATILTY F UND
Plus ça change – how Société Génér

market analysis allow us to identify
the best times to execute trading
strategies that capture the risk pre-
mium. Having identified this source
of profit, we need to build a strong
investment process giving recurrent
returns, low volatility for returns
and a controlled risk. Our invest-
ment process rests on four steps:
■ Allocation process;
■ Investment opportunities;
■ Trading and execution; and
■ Risk management.
What is the history of SGAM’s

involvement in volatility arbitrage?
SG Group is one of the pioneers
in derivatives-based investment and
SGAM has had a large research
team dedicated to volatility analysis
since 2001, developing proprietary
tools to analyse volatility on each
asset class and underlying market.
The incubation period for the
main ideas behind SGAM’s first
volatility-based fund was 18
Bernard Kalfon, fund manager of Société Générale AM AI’s months before the first launch.
It is under Arie Assayag, the
Global Volatility Fund tells David Walker why volatility arbi- global head of hedge funds at
trage will remain as a strategy, and keep SGAM’s clients happy, SGAM, his leadership and vision
for the potention of the volatility
in a risk-adjusted kind of way and market, that we started the vol-
atility arbitrage venture at SGAM,
Why do you feel volatility arbitrage On the other hand, realised vola- This difference is usually called his involvement and commitment
has sustainability as a strategy? tility is the volatility of the under- the bias and is statistically positive has really been a driving force for
Volatility must be considered as an lying observed during the life of the for many underlying assets. us in this field.
asset class. Indeed, the volatility option, and is known at the expiry of The volatility arbitrage strategy SGAM management is comfort-
market is deep and liquid with aver- the option. To understand the vola- seeks to profit from this structural able with quantitative techniques
age daily trading volume over $1trn tility market, we can compare it to bias in option markets, which serve and very familiar with treating
and only $5bn of assets are invested the insurance market. primarily as an ‘insurance’ market. volatility as a separate asset class,
by hedge funds in this area. If you buy a car and want to Chart 1, below left, illustrates, in addition to understanding the
Besides, volatility represents a buy insurance against any eventual over the last decade, the reward associated risk.
measure of return fluctuations of damage, you pay a premium to get (positive bias) for selling volatility In many ways, the SGAM AI
underlying over a period of time. On rid of that risk. The insurer will be (implied volatility) in the S&P 500 Global Volatility Fund is the culmi-
one hand, implied volatility is deter- rewarded by a premium to take this index options market. nation of the group’s efforts over the
mined by the market and measures risk, a premium valued through sta- Actually, implied volatility has last five years. Signals have been
the expected volatility of the under- tistical models. Similarly, on finan- tended to be ‘overvalued’ as com- improved and managers have looked
lying during the option’s life. cial markets, some investors are pared with “realised volatility”: for new, permanent opportunities.
eager to buy protection against the simply stated, like an insurance During this development period
evolution of a specific underlying market, the options market offers we offered some clients an overlay
CHART 1: S&P 500 (03/03/94–19/05/04)
price in the future, then buy protec- a premium to sellers of volatility. program on fixed income and equi-
50 tion called an option (with maturity The overvaluation of the implied, ties ($350m AuM) using the same
45 corresponding to the horizon of compared to realised, volatility has quantitative technology.

40 their risk) to avoid this risk. But tended to be the natural market equi- The SGAM AI Global Volatility
35 doing so, they must pay a premium librium across all three asset classes. Fund benefits from being part of a
30 (cost of the option) directly linked In practice, options often trade large organisation with dedicated
25 to the level of implied volatility. at prices assuming an implied vola- risk control and derivatives experi-
20 Thus, as in insurance where the tility with a significant discount ence. Launched in June 2005, the
15
insurer is rewarded by the premium or premium to the theoretical price fund seeks to generate returns by
10 minus cost of the damages until the based on observed historic volatility. capturing the risk premium of
5 end of the insurance contract, sellers By combining option positions and options traded in the major stock
0
of an option on the volatility market hedging tools, attractive risk/reward market indices, interest rates and
0 5 10 15 20 25 30 35 40 45 are rewarded by a risk premium cor- scenarios can be created. foreign exchange. The fund trades
Realised volatility (%) responding to the difference between Our sophisticated and propri- listed options on major global equity
Source: SGAM
the implied and realised volatility. etary quantitative methods of indices (US, Europe, Asia), govern-
20 | VOLATITLTY ARBITRAGE SUPPLEMENT | July 2006 www.hedgefundsreview.com

FUND PROFILE : SGAM AI G LOBAL V OLATILTY F UND
rale AM profits from option volatility

ment bonds and over the counter specialisation in Finance. indices and interest rates) as they positions optimising risk utilisation.
options on major global currencies. In addition, our research team are very liquid and offer the same For example, no short position on
The strategy seeks to profit in is a key resource in such a fund. It kind of structural bias as European options with small delta will stay in
the option markets by selling the has five people with a high profile and US markets. As we have a trad- the portfolio, as premium (reward) is
most ‘overvalued’ protection (short and strong expertise in quantitative ing centre in Tokyo with a senior minimal and loss unlimited; for the
volatility book), buying the most analysis, and the team is 100% com- hedge fund manager dedicated to same risk there are better options
‘undervalued’ protection (long vol- mitted to the volatility program. The the SGAM Global Volatility Fund, to sell giving a higher reward. They
atility book), while simultaneously research team has great interaction we can trade new underlyings and also helped model and build intra-
hedging out market risk through with the fund managers in order to add value and diversification to the day risk management techniques
‘delta hedging’. Given the struc- model all the ideas and treading global portfolio. In the future, the allowing the fund to reduce its risk
tural bias in the options markets, techniques. commodities markets could offer exposure during extreme market
over time the fund will have a net opportunities for the strategy if conditions: options buy-back, proac-
short volatility bias. Risk Control liquidity on their options markets tive intraday delta hedging.
The fund benefits from an inde- becomes sufficient for arbitrage and
What is your team’s experience? pendent risk control team of 23 if a strong long-term structural bias Do you employ stop losses?
The Global Volatility Fund is run by members. SGAM has an inde- is identified. We do not employ pure stop losses
two highly experienced managers. pendent risk department reporting in the cash or futures markets, but
Bernard Kalfon, hedge fund to the parent SG Group Risk Con- Are you not involved in some mar- we do utilise dynamic hedging
manager, is a derivatives expert trol Department. Of the 23 mem- kets because appropriate instru- algorithms in markets where we are
with more than 12 years’ experience bers, three are dedicated full-time to ments do not exist, or the market short volatility to limit our losses
in derivative products, working in alternative assets and monitor the itself does not have favourable on trading days when sharp move-
FX for Salomon Brothers, Citibank SGAM AI Global Volatility Fund. characteristics? ments well beyond one standard
and Bear Stearns in London. He ran If we are not involved in a market, deviation occur.
multi-billion-dollar derivatives port- What is SGAM AI Global Volatil- it is very often because of a lack of We have determined concerning
folios (vanilla and exotics) in major ity Fund’s investment universe? liquidity or because the correspond- levels at which we should initiate
currencies and developed strong We only use very liquid underlying options market doesn’t exist. We dynamic hedging – levels are deter-
skills in risk ings and instruments including all also need to identify a long-term mined through statistical studies
management listed derivative positions. We do bias between levels of implied and that define where the possibility of
and propri- not invest in single stocks, emerg- historical volatility before thinking retracement to the opening level is
etary trading. ing markets foreign exchange or about investing in this market. We negligible and probability of con-
Bernard illiquid bond futures, thus provid- will increase market instruments tinued movement well past the first
Kalfon joined ing us with a low sensitivity to only if we identify good opportuni- standard deviation is quite high.
SGAM AI in specific events. There is usually a ties on a specific liquid underlying. We dynamically hedge, buying the
April 2000 as bias in options markets linked to: cheapest gamma options available.
a senior hedge ■ Asymmetry of the supply and You trade locally but manage risk These are determined daily in all
fund manager demand profile globally. Why? markets we actively trade.
and has been involved, since the ■ Insurance value Fund managers’ expertise and loca-
beginning in developing the vola- ■ Intraday volatility tion (Paris, New York and Tokyo) What conditions favour your strat-
tility arbitrage program. He is a post ■ Local market characteristics ensure best liquidity access, opti- egy and which make life difficult?
graduate in finance & economics Our investment policy is based mal execution, and global full-time We should perform well in all
(La Sorbonne University) and has a on this observed bias. Our man- risk management coverage. types of market. However, because
Masters in maths. agers identify periods when selling of the long-term bias observed in
or buying short-term options and What filters/controls help minimise the option market, we will have in
Daniel Mantini, hedge fund man- buying long-term options is profit- the effects of exogenous shocks? general more selling strategies than
ager, has 20 years’ experience in the able. We seek to capture value from The combination of the fund man- long ones. Our models help us avoid
financial markets and joined SGAM the inefficiency of various options agers’ expertise and dynamic risk adverse market configuration, but
AI in February 2005 as a senior markets. Based on quantitative management techniques allow the of course will not be able to predict
hedge fund manager. He has man- techniques, we analyse the markets fund to preserve at best the investors’ exogenous impacts (terrorist attack,
aged the global foreign exchange within each asset class, then build capital in critical market conditions. for example) like many others strat-
options trading groups for Bear a portfolio which extracts the value Fund managers will always build egies in the market.
Stearns, Salomon Brothers and of volatility while maintaining a
PaineWebber. market neutral position. We invest in
He started his trading career the volatility of three asset classes: FUNDAMENTAL FACTS
with Shearson Lehman Brothers foreign exchange (major FX cur-
in 1987 and moved to Tokyo in rencies), interest rates (US, Japan, Management company’s name: SGAM
1988 to establish the Asian foreign Europe and UK bonds), and equity Full name of fund: SGAM AI Global Volatility Fund
exchange options desk. (US, Europe and Japan indices). Investment manager: SGAM Alternative Investments
More recently, he has success- Custodian: Societe Generale
fully traded foreign exchange, How have you seen the universe for Annual fee: 2%
equity and commodity derivatives investment by funds evolve over Performance fee: 20%
at several hedge funds. the years?
Fund type: Unit trust
He has a BSc in Mechanical The universe of investment has
Engineering from the University grown since our program’s launch. Domicile: Ireland
of Pittsburgh and an MBA from We are more and more interested Share classes/currencies: Euro, GB£ Yen US$
the University of Chicago with a in Asian options markets (equity Minimum investment: $250,000

FUND PROFILE : TITAN CAPITAL GROUP
Titan Capital Group – a universal volati

Titan Capital Group offers investors a global volatility fund – Titan Global – and Asian and
US variations. David Walker examined the range and philosophy at the group
What is the case for the sustain- trading is directional, with equity This led to panic buying of related to any market or hedge fund
ability of volatility arbitrage? options traded for yield enhance- options such as the December index stategy. Using data from the CSFB
Volatility arbitrage has become quite ment and index options primarily puts. The large disparity among Tremont index, our global product
a broad category, encompassing for insurance. Irrespective of which implied volatilities created good since inception to the present has had
both directional volatility players, purpose the options are used for, opportunities. The sell-off in May a correlation of -0.15 and posted posi-
mostly on the long side, and rela- supply and demand by directional 2006 is a similar event which has tive returns 100% of those months
tive value, meaning long and short players dictate the price and thus also created very good opportuni- where the index was negative. This
options thus making your volatility assign different implied volatilities ties. In Asia in 2004 performance is the real value we suggest people
exposure, long or short, depend on for different options. was mainly driven by a mania in examine – that as a true portfolio
the market level. The level of opportunities in Japan. With that market run-up you diversifier that adds value when other
We trade a relative value strategy, any market is a function of option saw many foreign investors who strategies perform worst.
which we believe is very sustainable, trading volume and the sentiment of had been historically underweight
primarily because the vast majority investors – meaning whether there Japan, and making money taking on Where some of your funds are more
of options are traded as either yield is panic or mania occurring versus a the basis risk, needing to gain quick focused, how do you maintain a
enhancement strategies or as a form boring, stable market. exposure. They did this by buying diversified portfolio?
of insurance on one’s portfolio, The best environment for the call options on the market, leading to Diversification is a central theme to
and thus each particular strike or strategy is one where investors panic great disparities between the implied our strategy as we are statistically
expiration option will trade on its and begin buying options to protect volatilities on the sought-after strike driven. In terms of obtaining proper
own supply and demand resulting their portfolio. During these “panic and expiration call options and other diversification there are thousands
in options on the same underlyer environments” buyers become least options. of different strikes and expira-
trading at different implied volatili- price-sensitive and will pay signifi- tion options between the different
ties. Our strategy then takes advan- cant premiums to buy certain strikes What markets does Titan Global underlyers from the indices to single
tage of these differentials. Although or expiration options. Similarly in a trade? stocks to choose from.
these differentials are much greater mania environment speculators want We focus on the US, Japanese, Korea,
in high or increasing volatility envi- to gain quick exposure to a market Hong Kong, and we intend also to Could you explain the difference
ronments, they are also available in run-up and thus are less price-sen- add Europe, though we would trade between relative-value positions and
low volatility environments. sitive in their decisions to buy call in any market with sufficient oppor- long volatility insurance positions,
options on the market, thus making tunities and liquidity. For underlying and how you use each?
Which funds do you run in the these options trade at a significant assets – we focus on equity and fixed Relative-value positions refer to long
strategy? premium to other options with dif- income. and short option positions on the
All our funds utilise the same trading ferent strikes and expirations. same underlyer. Relative-value posi-
strategy. The difference between the The greater the differential What capacity do your funds have? tions are the engine to the portolio.
funds is in the markets they trade and between implied volatilities between $2bn These trades can be broken into three
underlying assets. Titan Global M options – or the higher the fear or groups: skew, forward volatility and
trades volatility on equity and fixed euphoria in the market – the greater And performance of Titan Global, dispersion trades.
income and can expand into new the opportunities for the strategy. In and Global M? Like all relative-value strategies,
underlying assets. Our other funds a low volatility, stable environment Titan Global M was up over 5% there are certain risks that cannot be
trade solely equity volatility. opportunities are fewer. Interest through 31 May and Titan Global diversified away. These “path” and
rates also affect opportunities, in around 4.75% through 31 May. “tail” risks we acknowledge, and use
Could you explain the different that a low volatility, low interest rate Global M began, effectively, on 1 “long-volatility insurance” positions
classes and Titan Global, and give environment is the most difficult for February 2006, while Titan Global to hedge out and bring our risk to
insight into the different returns and the strategy. Low interest rates foster began in August 2001. acceptable levels. These positions are
volatility of the classes? yield enhancement strategies, such not put into the portfolio to generate
Titan Global has two share classes. as covered call writing, which lead You note in US, Europe and Asia returns, but always to be able to con-
Titan M trades volatility across var- options to be sold down significantly there’s been “dramatic growth in trol risks, including those perceived
ious assets with the focus on fixed as investors do not have opportu- option volume” – does this mean as improbably or even impossible, but
income and equity, while the other nities to gain yield through other capacity has grown, and how does that do happen.
share class exclusively trades equity avenues. The past few years have volume growth affect growth in
volatility. As Titan M is more diver- marked the most difficult trading products? What ‘supporting evidence’ is there
sified it will have more consistent environment for volatility arbitrage, Opportunities are clearly a function that Titan “when added to a port-
returns. However, because it is more fortunately with interest rates now of option trading volumes. If we were folio, reduces variance of returns
diversified than the equity-volatility- at more normal levels, 2006 looks to try to trade some exotic OTC option while increasing expected returns”?
only funds if there is a problem in the like a very promising year. we would probably come up with the The best evidence is the numbers.
equity markets but not in the others same price as the dealer we called. If one takes the CSFB Tremont
its upside potential will be less. Could you explain for example the Where supply and demand push the Hedge Fund index and runs the
differences in cumulative returns, in market price away from the theoret- normal statistics and then runs the
How do the regions differ from the 2002 for Titan US, and in 2004 for ical creates opportunities for us. same with an allocation of 12% in
global universe in their manifesta- Titan Asia? Titan for example, you find over the
tion of volatility, cycles of volatility 2002 was a very good year for Is any region you’re active in gener- past four years the index alone has
and opportunities for trading? our US strategy. The first one and ally more correlated to traditional a standard deviation of 3.07 – how-
Regardless of the market, opportuni- half quarters marked a period of asset classes and/or other hedge ever with Titan included it would
ties are driven by directional option declining volatility and then we saw fund strategies? have a standard deviation of 2.76.
trading. The vast majority of option a market dislocation occur in July. Our strategy is completely non-cor- Just looking at downside standard

FUND PROFILE : TITAN CAPITAL GROUP
ility remit with a regional twist

deviation, it goes from 1.4 to 1.11. How and when are gains from the what the option will be worth over edge. The average duration of our
One’s maximum down month funds locked in for investors? its term. The main reason we only portfolio is two to three months,
would decrease from -1.35 to -1.07. Gains are locked in by rehedging trade volatility is we like to stick but we will trade options up to a
The Sharpe ratio would increase the position. To hedge out the with where we feel we have a true year out.
from 1.74 to 1.83 and the Sortino option’s directional component,
from 4.44 to 5.27. Returns would stock is always bought or sold OVERALL PORTFOLIO
either increase or remain the same against it. Daily movement 1% 1.19% 1.37% 1.56% 1.88% 2.5% 3.12%
depending on which Titan product A simple example is if we were
is used. This is the real value that long an ATM call option we would Realised volatility 16% 19% 22% 25% 30% 40% 50%
we provide to an investor, we make be short .50 shares of stock. When -50% 30.9% 35% 37.6% 39.6% 42.4% 49.2% 52.7%
their portfolio more stable while at the stock moves we would buy or -25% 6.8% 10.9% 13.7% 15.9% 18.5% 23.2% 26.2%
the least not hurting performance sell stock for the position to remain -15% -1.5% 2.7% 5.4% 7.2% 9.1% 12.3% 15.3%
and most often increasing it. delta neutral. At this point gains -10% -5.8% -1.1% 1.5% 3% 4.4% 6.3% 8.9%
have been locked in.
-5% -2.8% 0.1% 1% 1.3% 1.3% 0.7% 2.4%
How have Titan’s products gener-
ated positive returns 77% of the You mention ‘superior execution Index unchanged 5.1% 3% 1.5% 0.5% -1% -3.7% -3.1%
months the CSFB-Tremont HFI fell? capabilities’ – how does execution 5% 7.9% 4.1% 1.9% 0.3% -1.6% -5% -5.1%
Most hedge fund strategies have an add value at Titan? 10% 7.4% 4.2% 2.1% 0.6% -1.1% -4.5% -4.9%
embedded short volatility compo- Given the large spreads in trading 15% 10.9% 6.8% 4.5% 2.9% 1.2% -2.1% -2.6%
nent, in that the strategy’s success options – especially in percentage 25% 11.5% 7.4% 5.1% 3.1% 1.2% -2.1% -2.6%
relies on assets moving as they are terms – where you get executed
expected and are hurt by dramatic at can often mean the difference RELATIVE VALUE POSITIONS
increases in volatility, which typi- between profit and loss. We have Daily movement 1% 1.19% 1.37% 1.56% 1.88% 2.5% 3.12%
cally accompany market disloca- over 50 years’ combined trading Realised volatility 16% 19% 22% 25% 30% 40% 50%
tions. Most people would agree, if experience and relationships with
-50% -10.1% -6% -3.4% -1.4% 1.4% 8.2% 11.7%
one measured correlation between all the option trading desks.
the various hedge fund strategies -25% -10.2% -6.1% -3.3% -1.1% 1.5% 6.2% 9.2%
during tail events it would clearly You stick to short-dated, liquid -15% -9.5% -5.3% -2.6% -0.8% 1.1% 4.3% 7.3%
show they become correlated at instruments – what are the dangers -10% -9.2% -4.5% -1.9% -0.4% 1% 2.9% 5.5%
exactly the worst times. If one of investing more in longer-dated -5% -3.8% -0.9% 0% 0.3% 0.3% 0.3% -0.3%
accepts my position, then our per- or illiquid instruments?
Index unchanged 5.5% 3.4% 1.9% 0.9% -0.6% -3.3% -2.7%
formance makes complete sense in Our edge is not in predicting supply
light of the index performance – and demand, it is valuing options 5% 8.5% 4.7% 2.5% 0.9% -1% -4.4% -4.5%
this is a key reason why every hedge and constructing an overall option 10% 7.4% 4.2% 2.1% 0.6% -1.1% -4.5% -4.9%
fund portfolio should include some portfolio with a very good risk 15% 8.3% 4.2% 1.9% 0.3% -1.4% -4.7% -5.2%
volatility exposure. reward. What we do is very similar 25% 8.5% 4.4% 2.1% 0.1% -1.8% -5.1% -5.6%
to fixed income arbitrage – one way NB: The most-likely scenarios are in redline bold
You mention ‘quantifiable down- of explaining it is, if you are trading
side exposure’ in your funds. With a five-year bond, you are concerned MANAGER/TRADER BIOGRAPHIES
how much precision can this be with both default risk and interest
predicted? rates, however trading a bond with Russell Abrams, portfolio manager, has extensive experience managing
Our risk management is based on two months to expiration you can be options portfolios and trading index and single stock options. Before
scenario analysis and stress tests much more comfortable focusing on forming Titan, he was co-head of US equity derivative trading and con-
that have always been extremely only default risk. vertible arbitrage at Merrill Lynch (1997-2000). He spent the previous
accurate. This is because we are Similarly with a long term option five years at Bank Paribas, then CSFB. During 1992-1993, Abrams
focused on short-dated options your P/L is more a function of worked with Fischer Black researching derivative strategies at GSAM. He gradu-
which, similar to bonds, have a fair what the market values that option ated from Boston University in 1988 with a computer science degree and received
value, reached at expiration. Our – meaning supply and demand for his MBA in Finance in 1993 from NY University Stern School of Business.
weekly risk reports to our inves- that particular strike and/or expi-
tors show all our exposures. ration, and a lot less to do with Senior traders
Mark Neuberger focuses on trading single stock options and iden-
tifying new single stock option opportunities. He spent 23 years at
INVESTMENT PROCESS Morgan Stanley, where as a managing director he ran US equity option
trading (top derivative desk for more than 10 years by McLagan Part-
ners). As the most senior trader in the equity division, he represented
Portfolio
it in risk meetings and on the risk committee helped set risk levels for the trading
avg. 3 month division. He graduated from Boston University (1981) with a degree in finance.
duration
Long Volatility James Y. Xu focuses on trading volatility on fixed income products.

Insurance Positions Before Titan, Xu worked in fixed income for over 12 years as head of
Add positions to mitigate downside exposures
interest rate derivatives research at JP Morgan Chase (1993-1997)
Risk Management developing many of the quant models. In 1998, he became head of
Sensitivity analysis of all probable & improbable events
interest rate exotic option trading. He has successfully traded interest
Positive expected performance rate options for several years focusing on volatility arbitrage. He has PhD in
Relative value positions
Skew Trades, Forward Volatility Trades, Dispersion Trade
numerical modelling of combustion from Yale University where he won the Best
PhD award (Becton Prize) in engineering and applied science.
Source: Titan Capital Group LLC

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July 2006 l volatility arbitrage supplement

THE VOICE OF THE ALTERNATIVE INVESTMENT INDUSTRY

Head office 19 A mirror to volatility?

www.hedgefundsreview.com July 2006 | VOLATILITY ARBITRAGE SUPPLEMENT | 3

Welcome turbulence – how to mak

Implied volatility (%)

Front Month ATM Call Implied Vol 25

2003 2004 2005 2006 Stock Price

4 | VOLATILITY ARBITRAGE SUPPLEMENT | July 2006 www.hedgefundsreview.com

ke money from volatility arbitrage

www.hedgefundsreview.com July 2006 | VOLATILITY ARBITRAGE SUPPLEMENT | 5

Welcome turbulence – how to mak

6 | VOLATILITY ARBITRAGE SUPPLEMENT | July 2006 www.hedgefundsreview.com

Yen implied volatility

mispricings in volatility. An example

www.hedgefundsreview.com July 2006 | VOLATILITY ARBITRAGE SUPPLEMENT | 7

Welcome turbulence – how to make VOLATILITY IN A PORTFOLIO

money from volatility arbitrage characteristics (particularly on the

8 | VOLATILITY ARBITRAGE SUPPLEMENT | July 2006 www.hedgefundsreview.com

0.10 to 4.71%. Market volatility has come

FOOTNOTES AUTHOR: JAMES SKEGGS

www.hedgefundsreview.com July 2006 | VOLATILITY ARBITRAGE SUPPLEMENT | 9

From little acorns... a $900m business grows

www.hedgefundsreview.com July 2006 | VOLATILITY ARBITRAGE SUPPLEMENT | 11

Sigma Square – making money on b

egies, starting with dispersion And theta arbitrage?

12 | VOLATILITY ARBITRAGE SUPPLEMENT | July 2006 www.hedgefundsreview.com

both sides of volatility’s golden coin

www.hedgefundsreview.com July 2006 | VOLATILITY ARBITRAGE SUPPLEMENT | 13

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Keeping pace: the R&D imperative

www.hedgefundsreview.com July 2006 | VOLATILITY ARBITRAGE SUPPLEMENT | 15

16 | VOLATILITY ARBITRAGE SUPPLEMENT | July 2006 www.hedgefundsreview.com

www.hedgefundsreview.com July 2006 | VOLATILITY ARBITRAGE SUPPLEMENT | 17

LONG CALL OPTION LONG PUT OPTION SHORT VOLATILITY POSITION

SHORT STRADDLE LONG RATIO CALL SPREAD

LONG VOLATILITY POSITIONS

LONG BUTTERFLY LONG CONDOR

The rationale will allow the trader to profit, although

18 | VOLATILITY ARBITRAGE SUPPLEMENT | July 2006 www.hedgefundsreview.com

Stop loss: how volatility arbitrage

www.hedgefundsreview.com July 2006 | VOLATILITY ARBITRAGE REPORT | 19

Plus ça change – how Société Génér

What is the history of SGAM’s

45 corresponding to the horizon of compared to realised, volatility has quantitative technology.

20 | VOLATITLTY ARBITRAGE SUPPLEMENT | July 2006 www.hedgefundsreview.com

rale AM profits from option volatility

www.hedgefundsreview.com July 2006 | VOLATILITY ARBITRAGE SUPPLEMENT | 21

Titan Capital Group – a universal volati

22 | VOLATILITY ARBITRAGE SUPPLEMENT | July 2006 www.hedgefundsreview.com

ility remit with a regional twist

Long Volatility James Y. Xu focuses on trading volatility on fixed income products.

www.hedgefundsreview.com July 2006 | VOLATILITY ARBITRAGE SUPPLEMENT | 23

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