Too many investors believe alternative strategies are “black-box solutions” — or computer-generated trades executed automatically according to algorithms — that profit in up or down markets. That’s only partially correct, though. Black-box solutions do exist, but market direction does impact profitability.

The fact is that most hedge funds have a directional bias. Long/short managers must emphasize one direction or the other. Even hedged strategies such as covered call options writing (long stock/short calls) have a bullish bias.

But like anything, there are exceptions. The “dispersion” strategy is a case in point. Viewed as an “absolute return” strategy, its success or failure rests with how tightly the basket of stocks held in the portfolio tracks a broad-based equities index, such as the S&P 500 composite index.

The dispersion strategy is a “volatility” trade supported by a portfolio of long and short straddles. A “straddle” is an options strategy in which you simultaneously buy — or sell — a call and a put on the same underlying security with both having same strike price and expiration date.

For example, suppose the shares of Barrick Gold Corp. are trading at $50 each. A trader who buys a one-month $50 call and a one-month $50 put for a cost of say, $4 a share, does not care about direction. That’s because the long call will profit if Barrick shares rise and the long put will profit if Barrick shares fall. Profitability depends on whether the underlying stock is able to move up or down by more than the $4-a-share cost of the straddle.

With the dispersion strategy, the hedge fund manager is buying straddles on a basket of stocks that have a high correlation with a broad-based index, such as the S&P 500. So, the manager would then complete the strategy by selling straddles on the S&P 500.

In theory, the strategy works because index options almost always overstate volatility — meaning, options on the S&P 500 are almost always overvalued.

Traders believe the overvaluation exists because individual investors are typically buyers of index options. There is a bias toward the long side because the average retail investor cannot execute a covered call strategy with cash-settled index options.

There is also the view that individuals like to buy index options because it requires a single decision: is the market going higher or lower? This is opposed to options on equities, for which you have to make a decision about market direction, then choose the right sector and, finally, the right stock in the sector.

If the dispersion theory is correct, a strategy of consistently writing straddles on the S&P 500 should be profitable — except for the margin required to make such trades and the fact that short-term inconsistencies do occur.

The rally in September and October, which saw the S&P 500 rise by 17%, would have done serious damage to anyone shorting index straddles. To manage the risk associated with selling straddles on the index, dispersion managers buy straddles on a basket of stocks that have a high correlation with the S&P 500.

For this strategy to work, you have to believe that stock options consistently understate the volatility of the underlying stock — and there is literature supporting that position. One theory is that equities options are almost always undervalued because it is virtually impossible to quantify company-specific risk within the options-pricing formula.

How, for example, can a mathematical model be expected to quantify the risk of, say, a pharmaceutical company awaiting approval of a major new drug from the U.S. Food and Drug Administration? If the FDA approves, the stock rallies sharply; if no approval, the stock falls sharply. Pricing a straddle in that situation is mostly guesswork.

From a hedge fund manager’s perspective, the dispersion strategy has a decent track record, typically producing consistent returns of 1% a month. The risks, surprisingly, have very little to do with the pricing of the straddles — and everything to do with how well the selected basket of stocks tracks the index.

Should either side of the trade move offside, that negates the benefits of the perceived pricing discrepancy that exists between the equities and index options.

The dispersion strategy has gained popularity among the hedge fund crowd, mainly because it eliminates directional bias and tends to trade differently than typical long/short strategies. Thus, this makes the dispersion strategy a nice diversifier within a fund-of-hedge funds strategy. IE