A similar situation arises with short volatility traders but potentially to a greater degree because not only does a successful strategy rely on accurate security selection but also having the ability to short the appropriate securities. Arbitrage volatility investing seeks mispricing on a relative basis and will not take a view on the direction of the markets but will take a view on the relative value of the securities on offer and the expected or “implied” volatility in the markets. This results in a market neutral volatility strategy.

In strategies where there is a requirement to be able to accurately forecast the direction of volatility, there is a chance that the manager might get the direction wrong, and depending what securities he/she is holding, there is a reasonable chance of underperformance in volatile market situations. The volati lity lan dscape Volatility investing is relatively new to the institutional markets. It has until recently only been undertaken by major banks in the US, and very successfully at that.

To date the banks have not seen the need to take the strategy to market due to the available trading profits they were achieving within their own domains. There are still relatively few volatility managers operating, and there are some fund managers who are really directional equities traders rather than seeking to focus on volatility trading as a strategy. Whilst acknowledging the various forms of volatility strategies undertaken by a variety of managers, the strategy I would like to focus on is market-neutral and non directional in nature.

Having previously run a super fund with a strong risk management culture, I have formed the view that when embarking on any new form of investing, it is most prudent to look for sufficient controls which do not offer serious impediments to the effectiveness of the investment process. Examp le of an Equity Index Volati lity Strategy •Inefficiencies exist within the equity index option markets •Options have a finite term and will revert to true value at expiry •Volatility Strategy trades equity index futures and options – eg. S&P 500 options (where the underlying asset is the S&P 500 Index) are traded on exchanges such as the Chicago Board Options Exchange (CBOE) and Chicago Mercantile Exchange (CME)

• Trading opportunities are assessed by comparing current implied volatility (VIX) with historic volatility in anticipation of reversion to an expected value – VIX is the ticker symbol for the CBOE Volatility Index (sometimes referred to as the “Fear Index”) which is a popular measure of the implied or expected volatility of S&P 500 Index options. •Analysis and assessment of volatility curves, option prices and portfolio risk characteristics facilitates trading decisions and execution of trades • Success of this approach relies on sophistication of underlying risk management software and pricing models combined with experience and skills of the derivative traders – there are relatively few participants with the necessary skills to successfully trade these markets.