Theta Capture, a long-short hedge fund managed by Athens, Ga.-based Liberty Street Asset Management, is hedging its exposure to falling equity markets through VIX trades. Tom Greene, the firm's founder, said, "We're betting the market is going up, but if we are wrong, we're protected." The theory works because of a negative correlation of around 80% between the equity markets and volatility, explained Greene.
If the market goes down, and volatility goes up, Liberty wants to be long the VIX. Greene said the firm has figured out how to calculate the amount of VIX that should be rationed against positions in the Standard & Poor's 500. "How we figure this out is part of the black box," he added.
"As volatility becomes more understood and more utilized, which we think it will, I'm sure we'll expand our repertoire," Greene added. "The VIX future is still a relatively new trading instrument so we continually have to respond to changes in the trading patterns and that's a lot for now," he said.
The firm has been using the VIX since the index began trading in March. "We make a profit by engaging in volatility arbitrage with the option," Greene said. If the firm wants to protect itself in case of sudden, large market movements it might buy far out of the money call options, he said. "We really don't expect it to come into play, but cost is very low and if you are short the market and it went haywire to the north, you would do very well on it," he said.
Volatility has a much higher degree of negative correlation than things that have traditionally been used such as gold, opined Greene. "If you were to have a long portfolio you could buy index puts and hedge that portfolio, but the cost is quite significant," he said. "We can turn the cost of hedging into a profit center."
Theta Capture, formerly known as Liberty Street High Income Partners, launched in July with an undisclosed capital.
