Hi Ted,

Apologies for the delay. The fourth of July holiday and the difficulty of the question slowed me down a bit. I checked in with two friends who graduated from Stanford's Graduate School of Business and now work at top-tier hedge funds. (Sorry, I can't say which funds (you know how secretive that world can be!) This is a fairly technical question and I probably can't give you an exact answer without knowing the name of the fund and studying its prospectus. But I'll do my best. Warning: this answer uses some industry lingo and assumes some understanding of volatility arbitrage.

For other FiLifers who have a basic understanding of options, here is some background:

An option is, by definition, something that's replicable using some combination of the underlying stock and interest rates. A "delta-neutral" position is one where you buy an at-the-money call and short the underlying stock (or the reverse). The delta can be thought of as just how much of the underlying stock you'd need to buy to replicate the option.

Options are priced in volatility terms. Higher (or lower) volatility of an underlying stock makes an option more (or less) valuable, since there is a bigger (or smaller) chance that the option will expire in the money. A higher price for an option usually means a higher implied volatility of the stock in the future. If actual volatility were to come in even higher than the implied volatility, you'd make money if you were long the volatility in the option (and vice versa).

Imagine this example: the stock you shorted goes up-- you lose money on the short but make it back on the call. You capture an additional gain if the implied volatility of the stock went up. The intrinsic value of the option would be worth more (the stock is now higher than the call price), and the expected future value (which comes from the implied volatility) is also higher.

Ted, you're right. Market-neutral managers consider how the volatility of the market is affecting their portfolios.

As you note, the VIX (the Chicago Board Options Exchange Volatility Index which measures the implied volatility of S&P 500 index options) is inversely correlated with the S&P 500. There's some argument that the correlation is skewed a bit greater when the S&P is trending down. This means that as stocks fall, the implied volatility of the market goes up (and vice versa).

But as a contact at one fund points out: "the VIX only describes the volatility of the S&P and is a function of the at the money contracts. While it is the case that high volatility of the VIX is correlated with downward price action by the SPY, that is not the case for single securities dispersed along various strikes. If the strategy is a portfolio of names, then the VIX is inadequate to describe exactly what is happening with respect to volatility."

I'm guessing that your fund is concentrated in a subset of the S&P 500. So it would be clumsy for your manager to play off the VIX to manage the market neutrality of the portfolio. It's more likely that the fund incorporates the manager's read of the market into each position held. The fund probably goes both long volatility (by buying options) and short volatility (by shorting options) based on the manager's prediction of whether volatility is priced correctly or not.

According to my friend at another fund: "This is literally what volatility arb is--making directional bets on whether implied vol will rise or fall when the underlying moves based on some proprietary model you have. Presumably that model corrects for the bias built in to vol moves from the overall market, the market neutrality of the fund in that case will be a function of how well the manager does in getting those bets right."

My friends provide an example:

"I think volatility is going to increase. I am a buyer of options. My original position is a SPY, I would buy puts on the SPY (short the market) "Delta adjust them" so I am left with ONLY my long volatility position. Let's say I have the same SPY position, but I think volatility in the market will decline. I would then short calls according to that particular call's delta, and be left with a short volatility position. (I have simplified by using the SPY as an outright long position. In practice you would only use options and it gets slightly more complicated (but it's not that bad).)"

I hope this helps.

Kristen

Hi Ted,
Thanks for the question. I'm checking in with a few of my sources in the hedge fund world to make sure I give you the best answer. I'll be back with an answer soon. Please stay tuned...