Those new to the hedge fund industry often find the concept of “buying volatility” and “selling volatility” to be somewhat confusing.  Volatility, after all, is not a tangible thing that can be bought and sold (save for the VIX), but is rather a description of tangible assets (a “volatile stock” or a “low-volatility fund”).

Yet hedge funds are often accused of simply “selling” volatility to generate returns, resulting in them being “short volatility”.  A short position in a stock implies that you would gain if the stock went down and lose if the stock went up.  Similarly, a short position in volatility implies you would gain if volatility went down and lose if it went up.

So how could you construct a position that would gain when volatility goes down and lose when volatility goes up?  Sell (i.e. write) options contracts.

Not unlike writing an insurance contract, writing options generates a steady stream of premiums with no apparent cost – until the judgment day comes.  In other words, if volatility unexpectedly jumps (as it does in severe market downturns), then you’d have to pay the piper.  Obviously, this could erase all of the apparently risk-free returns you seemed to be receiving by writing options over the the years.

Some say that’s how hedge fund managers really make their money.  Last year, we told you about a paper by Wharton’s Dean Foster and Peyton Young of Oxford University that claimed, among other things, that hedge fund managers routinely “fake” their alpha by simply writing puts and collecting the premiums (see post).  Wrote Foster and Young: More…