In a year when the world's biggest hedge funds are sufferinglosses and closures, one asset manager is trouncing rivals bybetting on currencies—without taking a view on their direction.

Quaesta Capital AG, a hedge fund based in the Zurich area, runsa $420 million foreign-exchange options program that earned 21percent this year through Nov. 11 by wagering on volatility,according to Thomas Suter, the company's chief executiveofficer. It's the top performer among 15 programs tracked by theParker Global Currency Manager Index, which lost almost 2 percentin that period.

The strategy, dubbed v-Pro, has profited by speculating thatswings in major currencies will grow more pronounced as theFederal Reserve moves to lift interest rates from near zero.It's the only strategy in the Parker index that focuses onvolatility, which has rebounded from a record low set in 2014.Quaesta uses dynamic delta hedging—a wager on volatility thatrequires constant adjustments to make sure it avoids taking astance on foreign-exchange movements.

“We're convinced the market will stay volatile in the future—theoverall levels on implied volatility are still not too high,” saidSuter, whose 16-person firm was founded in 2005 and manages aboutUS$3 billion. The key to the strategy is to “always include thedynamic delta hedging so you don't end up with a directionexposure.”

2015 Surprise

At a time when central banks' decisions are commanding theattention of financial markets, the program's returns show thatcurrency traders can make money without piling into the mostcrowded trades. In April, the consensus bet—that the Fed will raiseits target while other economies' policy makers add monetarystimulus—produced the biggest monthly loss in the dollar since2011.

A rebound in volatility in the $5.3 trillion-a-day market isdriving returns for the volatility strategy, which outperformed theParker Global index in seven of the past eight years. The fund's 1percent gain in 2014 compared with a return of about 3 percent forthe Parker gauge.

Events such as the Swiss National Bank's January decisionto remove its cap on the franc and the devaluation of the yuan in August by China's central bank roiledexchange rates. Implied volatility in major currencies hasaveraged 10 percent this year, up from 7.2 percent in 2014, thelowest annual level in JPMorgan Chase & Co. data goingback to 1992. The gauge has fallen below its 10-year average thisquarter.

Market swings have challenged some money managers that investacross asset classes. Some 417 hedge funds announced shutdownsin the first half, according to Hedge Fund Research Inc. BlackRockInc., the world's largest asset manager, is winding down amacro fund after losses and investor redemptions. It joins moneymanagers including Fortress Investment Group LLC and Bain Capitalthat closed macro funds this year.

To see further gains in volatility would require surprisingoutcomes from events such as the Fed and European Central Bankpolicy decisions next month, according to Credit Suisse Group AG.The euro sank to a seven-month low of $1.0617 this week onspeculation the ECB will expand monetary stimulus in December,while expectations build that the Fed is set to boost rates. Theshared currency was at $1.0690 as of 10:35 a.m. London time.

“Trading volatility can make money if there are mispricings involatility,” said Shahab Jalinoos, global head of foreign-exchange strategy in New York at Credit Suisse. “But now it's notas obvious, because volatility is much higher than a year ago.”

'You Always Have a Residual Risk… Hedging Is More ArtThan Science'

In Quaesta's strategy, picking which options to buy or sell isonly half the battle. In volatility trading, investors seek tocancel out delta, which represents the sensitivity of a derivativeto changes in the value of its underlying asset. The goal is forthe option position's value to change based only on volatility.

Take the example of a trader who owns call options granting theright to buy euros against the dollar. The contract loses money ifthe shared currency depreciates. To offset the spot market'sinfluence on the position, the trader could sell eurosperiodically.

It can be an expensive process. Options that can be exercised ata price close to the prevailing exchange rate will cost about 50percent of the trade's notional value to hedge, according toSociete Generale SA.

Delta hedging should be “performed at every millisecond, so it'snot technically possible and you always have a residual risk,” saidOlivier Korber, a derivatives strategist at SocGen in Paris. “Thehedging performance can be a loss, flat, or even a gain. It is moreart than science.”

–With assistance from Rachel Evans, Jennifer Surane, Liz CapoMcCormick, and Sabrina Willmer.

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