Hathersage Forex Trades Are All About Options

The fund of the “Sultan Of Currencies,” Bill Lipschutz, uses options as the main instrument for trading currency moves. Lipschutz thinks his approach, and returns, will appeal to institutions.

By Mara Lemos Stein, Hedge Fund Trades
Monday, June 26, 2006

Japan is poised to raise interest rates for the first time since 1994, yet going long the Japanese currency at this point could be costly, given that holding money in yen still means sacrificing interest income.

Options are the answer, according to Bill Lipschutz, one of the top traders profiled in the 1992 book The New Market Wizards, who is now running a New York-based foreign-exchange fund called Hathersage Capital Management, with about $150 million under management.

To Lipschutz, Japan’s prospective interest rate rise is one change in the macroeconomic firmament that will benefit discretionary forex funds such as his and spur on the flow of institutional money now entering foreign exchange. Indeed, he hopes to increase the assets managed by Hathersage to between $500 million and $750 million.

“I'm not sure if we’re going to see the 30% to 40% that the great global macro traders did in the 1980s, but I think that, with higher levels of interest rates and higher levels of volatility, the global macro approach will get an opportunity that hasn't been around for a long time,” said Lipschutz.

Hathersage uses options as the building block of its portfolio to express a directional view on a trade, using spot transactions as the modifier or hedge.

That means taking advantage of the relatively wider spreads in the derivative instrument when picking a currency pair as well as using the more liquid spot markets to do the hedging, Lipschutz said in an interview with Hedge Fund Trades. An options-based strategy also implies laying out a fixed amount of money, which limits any potential losses to that amount.

So buying a portfolio of euro/yen put options - which means having the right to sell the euro and buy the yen ­ with maturities from three to six months, would be a way that Lipschutz might set up a trade to play the tightening of monetary policy. Hathersage might also do some forward swaps to hedge the implicit interest rate risk in the longer maturity options, as it is unclear what either the European or the Japanese central banks’ next moves might be.

As more clues about central bankers’ actions emerge, euro/yen might trade towards 140, Lipschutz said, compared with a spot euro/yen level of around Y146 early Friday. If the market becomes less confident that the Bank of Japan will raise its interest rates in July, and then in October, a further drop - say to euro/yen 130 - will seem unlikely, he said. So the next move might be to buy some spot euro/yen to partially hedge the long put options.

In the meantime, the net portfolio delta - the relationship between an option value and the amount of underlying spot foreign exchange needed to be perfectly hedged - will have moved higher, meaning the position has become more leveraged. Also it would likely be the case that implied volatility had also risen, so in this scenario the manager could sell some at-the-money options to help finance the position. Any unforeseen, sharp movement in this imaginary course of events would prompt Hathersage to buy a spot position and go delta-neutral.

“If I'm ultimately right about the direction of the trade, then those options will become in the money, their delta will grow and the position’s leverage will increase,” Lipschutz said. “Generally speaking, there will be a pick-up in implied volatility as well,” which can either be managed with spot or turned into a realized profit by selling out the options. Prevailing levels of actual volatility also influence the time frame of trade ideas. Short-term time horizons have worked better in the low-volatility environment of recent years, he added.

The strategy has paid off for Hathersage investors. Its Long Term Currency Program has had an average annual return of 19.5% since inception in August 1991, while the Daily Currency Program launched in January 1992 has posted an average annual return of 14%. Both programs trade only G-7 currencies in the interbank over-the-counter, spot and forward markets.

Lipschutz has nearly 25 years of experience in forex, having started at Salomon Brothers in 1982 and rising to head the investment bank’s global foreign exchange-trading business by 1989. He sees growing interest among institutional investors in foreign currency as an asset class.

“We've reached a point in time when large, sophisticated institutions are getting interested in putting money into foreign exchange, and there just aren't that many experienced, active currency-only managers,” Lipschutz said.

One way that Hathersage is expecting to capture some of the institutional money coming into forex is through its participation in currency platforms that offer structured products. It already has its programs in Deutsche Bank’s FXSelect and SEB FX Managed Alpha Product, a platform run by the Scandinavian bank.

These platforms, which offer both discretionary and rules-based programs, are increasingly considered a clever way for pension funds to lower risk through diversification, as well as to add foreign exchange as an alpha generator in their portfolios. Typically, forex features in institutions’ books simply to manage exposure to foreign currencies in other assets.

Although a discretionary approach tends to make some investors nervous because of the implication that a manager’s judgment is so crucial for the trade, Lipschutz points to his track record, experience and risk management tools to counter these concerns.

Besides, as the world enters an era of greater uncertainty, the strategic approach of such funds will become more appealing for their ability to maneuver through market oscillations more nimbly. And the performance should show.

For managers whose decision process is based on judgment, returns in the year to April were 2.1% compared with a negative 3.3% return for those who use algorithms, according to the latest Parker FX Index published by Parker Global Strategies, a fund of hedge funds in Stamford, Conn.

In a more volatile market environment, systematic forex funds have a more difficult time trading as trends are less obvious, said Ian Stannard, senior currency strategist at BNP Paribas in London.

“Quite often we see these high volatility times during periods of change in the market environment, and it is during these periods of change that systematic funds will have their toughest time,” said Stannard.

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