Adam Stern, chief executive officer of $1 billion hedge fund firm AM Investment Partners in New York, had been gearing up for the inauguration of Barack Obama for weeks. Stern believed that the change of administration would be good for one of his main strategies: volatility arbitrage. “Our thesis was that coming out of 2008, investors were going to get more comfortable,” which would reduce volatility, he explains. But, he adds, the negative economic fundamentals would soon reassert themselves, fear would return to the marketplace, and volatility would soar again.
“The assumption is always that volatility lowers with the demise of unknowns,” says Andrew Barber, director of derivatives research at Research Edge in New Haven, Connecticut. “So when you know who the president is, it follows that volatility should go down.”
In a basic “vol arb” play, a trader looks for a volatile sector, say health care or finance, then buys or sells options on a stock, a basket of stocks or an index in that sector. These options can be either puts (the option to sell the underlying stock or index at a specific price and date in the future) or calls (the option to buy) — or both. A seller of options believes that volatility will go down. A buyer thinks that it will go up. As the value of the security fluctuates, so too does the value of the options. A put option becomes more valuable as the price of a stock drops; a call loses value.
The ultimate aim of a vol-arb trade is to be neutral on price but to profit on changes in that price. The arbitrageur also tries to make money through “gamma trading” — buying and selling the underlying security in the equity market. One way for the uninitiated to think of the trade is as trying to place a hedged series of wagers on a ball game using a language you barely know.
Here’s how AM Investment recently made such a trade. At the start of the year, it sold puts on JPMorgan Chase & Co. shares, with an expiration date of January 2010 and a strike price of $22 (the stock was trading at about $29 at the time). It also sold January 2010 calls with a strike price of $30. This structure, in equity-options parlance, is called a strangle, which is more out of the money than a conventional straddle. The bet, in this case, is against volatility, that the price of the security will stay within the band of the options. With the money it pocketed from selling the strangle, the fund bought put options with a $25 strike price and a February 2009 expiration. Those puts were hedged by the January 2010 strangles, and the long-dated/short-dated structure allowed AM to bet on a return to volatility without being crushed in a calming market. AM was also trading JPMorgan stock, as a way to generate additional income and try to keep the whole thing price-neutral.
Defying expectations, the VIX, the volatility index on the Chicago Board of Options Exchange “kept on rising” on Inauguration Day recalls Matthew Shapiro, who trades in the VIX pit for Stutland Equities. Fortunately for AM, its bet was neither one way nor one day.
By early February, with JPMorgan at about $25 a share, AM had made money from its gamma trading, and still stood to benefit from extreme price movements. Barely a week into the new administration, Stern and his team had already jumped on what they considered a temporary calm to buy more puts in several sectors — including, again, finance — in the expectation that poor fourth-quarter earnings reports would bring volatility roaring back (increasing the value of those puts). How they structured those trades was a whole other ball game.
