Robert Doherty, founder of Doherty Advisors LLC in New York, has more than 20 years of experience managing money, most of it on the proprietary trading side of large institutions, but he is on his own now after perfecting a relative value/market neutral volatility arbitrage strategy.
“We are totally agnostic as to the direction of the underlying market. We don’t try and predict where markets are going and more importantly to us is, we don’t try and predict where implied volatility is going,” Doherty says.
The strategy is 100% discretionary but doesn’t sound that way when you listen to the myriad of technical measures used. To put it simply —which is difficult for this strategy — Doherty measures the value of a group of options and buys undervalued strikes while selling overvalued strikes.
“We trade the volatility skew. We are combing all the different strike prices on the volatility skew in S&P 500 and 10-year notes and we are looking at different points that represent mathematical relative value. We are trying to buy strike prices with cheap implied volatilities and we are selling relatively rich strike prices against them using a delta neutral fashion,” Doherty says.
Doherty started trading on prop desks in 1988 shortly after graduating from Boston College with a degree in finance. He traded for Kidder Peabody, Fuji bank and most recently CIBC Oppenheimer. “I was trading yield curve arbitrage on notes and bonds. A lot of basis trading,” Doherty says. He began to trade options to hedge out unwanted exposure in his yield curve trading and he eventually saw that the options side could add alpha on its own. In 1994 he focused all of his efforts on trading the volatility skew. Then in 2001 some venture capitalists saw how consistent his returns had been and encouraged Doherty to launch his own fund and provided him with seed capital. The program was launched in 2003 and has produced a compound annual return of 8.27% with a monthly standard deviation of 1.43%.
Doherty says a key difference between his approach and other volatility traders is that he is always a payer of premium and also slightly net short options. He says this creates a hybrid for gamma neutrality that allows you to be profitable in ultra low volatility environments like in 2005-06, more historical volatility environments like 2003-04 and in the ultra high volatility environment of the last two years. “We have been profitable in all those different volatility environments. We like to think of ourselves as a strategy for all seasons, whether low, moderate or high volatility,” he says.
Despite his approach, the strategy suffered its worst month last October, -8.34% in the KBD Capital Partners fund, amid the market turmoil. “We would like to see the S&P go down 10-20% every S&P cycle because that is typically where we have our best profitability. What we didn’t like about last October is that it went down about 40% in a very short time period. “That is really the only type of time period we can get hurt in. We made some adjustment to leverage so we are much better prepared for it,” Doherty says. The program had only three negative months since 2003 prior to last September, none of which lost more than -2.1%.
“The most important thing to understanding the strategy is that while being slight payers of premium, we are slight net short options,” Doherty says. He also notes that they take no calendar risk, always trading options on the same underlying in each structure. He will trade 14 to 22 strikes up and down the curve for the same underlying. He will concentrate on the two nearby option cycles, never going out more than eight weeks.
“We look at different points in the volatility skew. Right now we are looking at puts [in the S&P 500] from 1040 to 720; on the call side we are looking at 1010 all the way out to 1170 calls,” Doherty says. “We are analyzing all of these points on the volatility skew, looking at the shape of the curve or the kurtosis of the volatility skew and looking at different points to buy or sell.”
He calls his strategy a 50/50 mix of art and science. “The art part of it is where the discretion comes in. We are using mathematics to make are own sound relative value decisions,” Doherty says.