An overview on the use of proprietary volatility strategies and their use for Alpha generation and portfolio hedging.

1. Equity Volatility Trading:
Diversified Proprietary Strategies for Alpha Generation & Portfolio Hedging
Contact:
David Hamilton
t: 212.217.1556 m: 917.499.7331
davidehamil@gmail.com

2. Strategy Defined
Volatility Arbitrage is designed to produce absolute, market-neutral returns.
• Strategy continually looks to exploit pricing inefficiencies in various
options classes to generate consistent profits.
• Trade duration might vary from a few weeks to a few months.
• Strategy uses only exchange-listed options on US stocks.
• Strict execution and oversight guidelines ensures:
– Reduced transaction costs and market impact (Proprietary trading
technology utilizes all available liquidity to ensure positions are initiated and
closed in the most efficient manner possible).
– Increased speed and effectiveness of Risk Management
(Proprietary tools also designed to identify and rapidly reduce risk across both
strategies).
2

3. Relative Value Arbitrage (1 Month Maturity)
10-Year Backtested Returns, Jan 2002-Jan 2012
Average (vols x 100)
Sharpe
Stdev
2002-2011 2010-2011
0.0300
0.0151
2.2601
1.3197
0.0459
0.0395
Bin Frequency
-0.06
5
-0.04
5
-0.02
15
0
30
0.02
50
0.04
40
0.06
42
0.08
25
> 0.08
28
3

4. Relative Value Arbitrage (3 Month Maturity)
10-Year Backtested Returns, Jan 2002-Jan 2012
2002-2011 2010-2011
Average (vols x 100) 0.0283
0.0286
Sharpe
1.8259
1.9300
Stdev
0.0537
0.0513
Bin Frequency
-0.06
6
-0.04
13
-0.02
21
0
28
0.02
39
0.04
38
0.06
30
0.08
25
> 0.08
31
4

5. Strategy Defined
Portfolio Insurance is a vitally important, yet often overlooked, element of
traditional and quantitative Long/Short equity strategies employed by
hedge funds.
When used properly, it should serve as a key component of the risk
management process, seeking to preserve investor capital by locking in
gains and preventing/minimizing any potential drawdowns.
Design and use of Portfolio Insurance can be outlined in the following steps:
• Identify Hedging Needs
• Hedge Valuation/Optimization
• Hedge Implementation
5

6. Hedge Identification
Determine key underlying risk(s):
• Entire/partial portfolio
• Net Beta exposure
• Volatility/Correlation risk
• Binary Event risk
• Tail risk
Underlying Strategy Time Horizon:
• Short Term (1-2 days)
• Medium Term (3 days – 1 week)
• Long Term (1 week+ )
Additional Consideration Factors:
• Momentum/Mean-Reversion Indicators
• Directional Indicators
Identifying all contributing factors in systematic fashion allows for efficient pricing,
construction and optimization of strategy hedges.
6

7. Hedge Valuation/Optimization
• Determine prevailing levels of implied volatility in the marketplace.
Valuation
• Can use simple comparisons to historical means or multi-factor
valuation model, using both technical and fundamental inputs.
• Develop Optimal Hedge given market levels, strategy timeframe,
available liquidity (stock-by-stock, group of underlyings or Portfoliowide) and additional indicators.
• Simple Hedges (Fixed-Strike Index Collar, Put Spread Collar).
Optimization
• Complex Hedges (Dynamic Index/Sector ETF Collar, Index
Variance, Futures and Options on Volatility (VIX), Synthetic
Correlation Plays, Customized OTC Instruments).
7

8. Hedge Implementation
Example – Ratio Collar on SPX
BUY: 1 6mo 98% Put
SELL: 1.5 1mo 101% Calls
BACKTEST PERIOD
Jan 1999 – Jan 2010
SPX Level at Start: 1,234.40
SPX Level at Finish: 1,150.23
PERFORMANCE
Avg. Return (monthly): 0.30%
Standard Dev. (monthly): 1.28%
Avg. Return (annualized): 3.60%
Sharpe: 0.81
TOP GRAPH:
Absolute returns, SPX + Collar v. SPX(in SPX points)
MIDDLE GRAPH:
Annualized volatility (SPX + Collar, SPX, Collar/SPX)
BOTTOM GRAPH:
Monthly returns, SPX + Collar v. SPX(in SPX points)
8