ALTERNATIVES - Panic Trading

Equity markets are calm, but volatility arbitrageurs are making money.

Many hedge fund managers were licking their wounds after a sell-off in Chinese stocks sparked a worldwide retreat from equity markets on February 27, but Adam Stern and Mark Friedman were celebrating. The co-founders of New Yorkbased hedge fund AM Investment Partners, which manages $750 million in assets, use the options market to proÞt from volatility. On a day when the Standard & Poor’s 500 index dropped 3.5 percent, the Chicago Board Options Exchange’s volatility index -- known as the investor fear gauge -- soared 64 percent. AM’s convertible arbitrage, equity long-short and volatility arbitrage funds all made boatloads of money.

The surge in volatility was welcome news for a Þrm that has managed to garner positive returns during a Þve-year stretch in which market gyrations sank to unprecedented lows. “If you wrote your letter to investors on February 26, you would have bemoaned one of the worst periods for volatility that you had ever seen,” says Stern, who is AM’s CEO.

Former convertible-bond salesman Stern met Friedman, the Þrm’s chief investment ofÞcer, when they both worked at Deutsche Bank in

the late 1990s. They launched AM’s Þrst investment vehicle, a convertible arbitrage fund, on September 4, 2001, just a week before the terrorist attacks on the Pentagon and the World Trade Center. In a nod to the reconstruction effort, AM has taken ofÞce space at 1 Liberty Plaza, a 54-story tower in downtown Manhattan that overlooks Ground Zero.

Volatility arbitrageurs like Stern and Friedman make their money from the difference between how the market perceives future movements in the price of

a security -- known as “implied volatility” -- and how the price actually changes over a speciÞc period of time. Traders can go long volatility by purchasing options and short volatility by selling them. They can express their views accurately thanks to the Black-Scholes options pricing model, whose inputs include an option’s time until expiration, its strike price, the price of the underlying security, the risk-free interest rate and an estimate of volatility -- which is usually expressed as the annualized standard deviation of price movements in a stock, index or other underlying security.

“If you are long volatility, you need realized [volatility] at least equal to implied [volatility] or you will lose money,” explains Ross Berman, co-founder of BAM Capital Management, a New Yorkbased manager of long-volatility hedge funds. Short-volatility players take the opposite bet: that implied volatility will exceed actual volatility, a trade that has paid off handsomely as market turmoil has declined across the board in recent years.

For long-biased managers, time is the enemy: Long-volatility positions tie up capital in options whose values “decay” as they approach their expiry date. At AM, Friedman trades his portfolio to recoup the loss. If the implied volatility of an equity option suggests an average daily move of $0.50 but Friedman expects a bigger move -- say, $0.75 -- he tries to capture part of that excess by buying or selling the underlying stock, a practice called “gamma trading.” Friedman, who began his career at legendary options shop O’Connor Associates, relies on sophisticated algorithms to identify such opportunities. When the stock market goes haywire on days like February 27, he hits the jackpot.

For the most part, though, relentlessly declining volatility has ensured that long managers like AM and BAM are far outnumbered by those who sell volatility. In

normal markets, option premium decay delivers returns as if the manager were clipping bond coupons.

“We make a little money on a regular basis,” explains Alex Ingham Clark, who runs sales, marketing and client service for London-based F&C Alternative Investments, which oversees nearly $2 billion in three short-biased hedge funds that trade volatility in equities, derivatives and foreign exchange. “If volatility spikes, we lose money,” he adds. “Then we make it up afterward.”

The trick for managers like F&C is to stay in the game when volatility spikes. The Þrm caps its exposure in over-the-counter derivatives contracts or buys out-of-the-money options to ensure that its funds will not only survive a big move but also have the Þrepower to sell more volatility at the higher level. In an era of low volatility, short-biased managers like F&C may have the upper hand, but days like February 27 ensure that long-biased managers will never become extinct.