Russell Abrams began his career in finance researching derivative trading strategies under Fischer Black, while working at Goldman Sachs in 1992 and 1993. Black, co-inventor of the Black-Scholes formula, a method for determining the value of derivatives, died in 1995, two years before his colleagues, Myron Scholes and Robert Merton shared the Nobel Prize in economics for their collaborative work. Russell then worked at Bank Paribas and CS First Boston where he gained significant experience trading derivatives in multiple markets. In 1997, four years after graduating business school, Russell was recruited to Merrill Lynch to build up and manage US Equity Derivative Trading. Under Russell’s leadership, the desk increased profits eight fold and became one of the most profitable equity derivatives desks on Wall Street. In early 2001, he founded Titan Capital Group to manage hedge funds using the same volatility arbitrage strategies he developed over his career and utilized at Merrill Lynch. The firm launched the Titan Volatility Fund, LP in February 2001 to trade US equity volatility as an asset class. In August 2001, they launched the Titan Asia Volatility Fund Ltd. to trade Asian volatility as an asset class. In March 2003, they opened a third product to outside investors, Titan Global, which dynamically allocates between the two other funds. The firm currently has $200 million under management and offices in New York and Hong Kong.
Profile of Russell Abrams
Born: August 26, 1965
Education: BA in Computer Science; MBA in Finance, NYU School of Business
Last vacation: Florida
Last book read: “Guns, Germs and Steel: The Fates of Human Societies” by Jared Diamond
Hobbies: Chess, wake boarding, scuba diving
Favorite quote: “Faith is the bird that feels the light and sings when dawn is still dark”
How he best describes himself: “I don’t predict the future, I prepare for it"
Q. Could you explain what is volatility arbitrage?
A. We trade the volatility component of options. For the same underlying security, we can trade the volatility of one strike price versus another or the forward volatility by trading one maturity versus a different maturity. Arbitrage opportunities exist because each option trades on its own supply and demand reflecting people’s view of the direction of the market. These options are not fungible, i.e. the payoff of one strike option is very different from the payoff of another option on the same underlying security. For example, right before the Iraq war, we saw a tremendous number of people buying call options on the S&P500 as they expected a massive rally. People were paying a very high implied volatility for the May 900 call because they were focusing on their view that the market was going to go higher. The volatility on these options became quite high relative to other options, for instance the May 800 put options that few people wanted to buy, creating a great trading opportunity. Investors have to eventually monetize their gains by selling these options, at which point volatility is driven down.
Q. Could you describe how trading opportunities in equity derivatives have changed over the last ten years?
A. Ten years ago, equity derivatives in emerging markets was a very popular business. Most of the trades were financing trades where people in emerging markets were seeking access to capital. They would do option trades as a form of a loan and the derivatives desks were much more aggressive in loaning money than the corporate banking groups. Those opportunities do not exist anymore given the better understanding of counter party risk by derivatives traders, especially after 1998. Within the developed markets, over the counter trades used to be the source of income. Most of the dealers would take advantage of their relationship with customers in the pricing of options. The investor base is much more sophisticated today and those types of trades have also disappeared. Options pricing, whether they are over the counter or listed, is very competitive. Within developed markets, the newest event has come from corporations which actively trade derivatives for yield enhancement strategies and also issue derivative securities instead of traditional debt. Individual investors have been much more aggressive in yield enhancement strategies; pension funds which had been active in yield enhancement strategies in the early 1990s stopped in the mid 1990s and are now coming back, especially for hedging downside exposure. Mutual funds generally have stayed out of the equity derivatives markets. In the last few years, we have seen major swings in volatility. Historically, volatility would gap higher and trend lower. Now volatility can gap lower as well. So volatility as an asset class has become more difficult and you have to be much faster and more focused on managing a portfolio rather than doing one-off trades.
Q. Could you describe the relative value and long volatility components of your portfolio?
A. Relative value trades are neutral to changes in volatility or directional movements in the markets. You are long and short volatility on the same underlying security and it is very similar to fixed income arbitrage when you can be long some bonds of General Electric and short other bonds of GE and have no credit exposure. Relative value creates very stable returns with very low risk of losing money and performs best in very stable markets. It is a form of providing liquidity to the market. However, while those risks are small, they could have very significant losses due to particular paths the underlying security might take. Relative value trading does not work well when you have a liquidity crisis and cheap options become cheaper and expensive options become more expensive. The long volatility portion of our portfolio is set up to hedge out the relative value risk for those very unlikely but very costly paths. That portion of the long volatility portfolio costs us 20% to 25% of the expected return of the relative value portion but creates positive returns during periods of financial dislocations. The total capital at risk in the long volatility portfolio overall is normally under 35 basis points a month.
Q. Could you describe the structure of your portfolio?
A. The relative value portion of our portfolio is long and short volatility in the same underlying security. We would not be long volatility on IBM and short on Intel for example. In general, we have options on approximately 50 underlying stocks and within each stock we may have 10 to 20 different unique option positions. We use actively traded options which are typically in the names that have high stock volumes. On the major indices, we may have up to 200 unique option positions. In the US fund, essentially all the options we trade are listed. In Asia, approximately 60% are listed and 40% over the counter. We do not have any straight equity positions.
Q. What is your process for selecting individual positions?
A. We are statistically driven and we look at the risk-reward of a trade. Before the day starts, we have levels which are set for all different types of trades and if those levels are reached, we implement the trade. The opportunities exist from imbalances in supply and demand which move the price away from what we see as theoretical. The universe is not so big and we look at the option trades all day long. We can also be opportunistic and react to certain types of major market news, for instance, the news of Philip Morris having to post a bond threatening bankruptcy. On the other hand, an earnings pre-announcement would not be significant for us.
Q. What about trade execution and exiting positions?
A. Execution is a critical aspect of our business since the bid-offer spread on an equity option can be 10% wide. It is the difference between making money and losing money. Most of the option markets are not electronic and most trades are done pre-arranged over the phone. Our business is very labor intensive and we are constantly interacting with the dealers on possible trades. In terms of exiting positions, we put on a lot of positions in the portfolio which by themselves may not make any sense but have significant additive value to the overall portfolio. If they start losing money, we don’t just get rid of them because that may have an unstable impact on the portfolio. We look much more at overall strategies if we sense they are not working out. We keep the duration of the portfolio quite short, around three months, and we focus on realized gains or losses more than unrealized gains or losses.
Q. What are your risk management tools ?
A. We are concerned primarily about what is causing losses. It is similar to someone owning a one month bond. If the credit spread changes, it is not nearly as important as if the company is going to default. Our risk management systems are very advanced and allow us to know, for any scenario, how our portfolio is going to perform. We don’t use value at risk models which require you to know the probability of events as we don’t think we can adequately estimate those. Thus, we look at all worst case scenarios irrespective of their perceived probability. Risk management is then used to manage the downside risk on a quarterly basis, with the maximum loss for a quarter always limited to 5%. The portfolio’s greatest risk occurs when highly unlikely events occur simultaneously while overall market volatility remains quite muted. Thus losses could occur in the relative value positions that the targeted long volatility positions would not be able to mitigate, and result in as much as a 5% loss over a quarter.
Q. Can you describe your organization?
A. We have eight people in New York and three in Hong Kong. The primary traders had previously worked with me at Merrill Lynch. We work on a statistical basis and the trading team has to be unanimous for a trade to get executed. The business side of our firm is run by Marc Abrams and Steve Cohen, both of whom I have known for more than twenty years, which allows me and the trading team to maintain a clear focus on trading.
Q. What are your goals for the future?
A. We would like to double our assets under management and then grow organically. We hope that, within six months or so, the European markets and the US market will start decoupling so that there will be diversification benefits from having European positions and we would expand trading volatility there. The hallmark of our organization is that we are a one strategy fund and we focus on what we think we are very good at, which is trading volatility as an asset class. We are not a multi-strategy fund and will not be adding other strategies into the fund.