Speaking of conversations best had around adult beverages, no doubt many of you have laid awake nights wondering, “How does relative value arbitrage work, and should I care?”

First, arbitrage isn’t bad. It’s a path to both profit and protection. Universa, the hedge fund advised by The Black Swan author Nassim Taleb, follows relative-value arbitrage techniques to help clients offset risks (Incidentally, Nassim Taleb remarked about the May Flash Crash that when a bridge collapses, you don’t study the last truck that crossed it; you look for structural flaws.). So the first thing to know is that gaps, or spaces, between things offer chances to profit from spreads and opportunities to guard against an equal but opposite risk. And this stuff will at some inevitable point affect the price of your stock, so it’s best to know about it.

Any trading strategy that focuses on the spaces between things rather than the things themselves is a form of “relative value” arbitrage. Global Macro strategies dominated hedge-fund investment in the 1990s, accounting for roughly 80% of assets under management. It’s not new. And it’s a form of relative value arbitrage. Global Macro techniques are widely used today, except at high speed now. For instance, have a look at indices from structured-products broker Newedge for volatility and macro trading, and you’ll see that they’re predicated on fairly small returns – and losses. Lots of little returns at nominal risk make sense when uncertainty abounds. So it becomes common in stocks too.

Let’s use you as an example. Say your stock trades for $20 right now. A trader with a relative value arbitrage strategy might buy an option, either on your stock or for an index, and then sell your stock for a “long” volatility position. Buying your stock (the underlying asset) and selling the option instead is a “short” volatility position, because the trader is short the potential, or implied, volatility. The trader profits in a long volatility trade if your actual volatility is greater than the implied volatility of the option.

Now that sounds complicated, and it can be. But realize that it’s about the volatility, not your price or the price of the option. Think about it this way. If your volatility is 25% over the life of this trading plan, while the volatility of the option is 20%, that’s a profit, regardless of what caused the spread.

Now suppose the trader is a “liquidity provider” too, offering shares for sale. Now the trader might be able to “move” the price of your stock with high-speed trades, while also holding a volatility play. This is fairly common. If your stock moves from $20 to $18 and back in a day, that could be enough for the trader to profit. What’s more, say you trade five million shares a day and the trader sat between 300,000 shares of that volume with a machine. The trader might’ve pocketed $1,500 on this activity too, as gravy. Duplicate that in a portfolio trade of 30 liquid stocks and combine it with relative-value arbitrage plays, and pretty soon you’re talking real money that’s almost as easy as a government bailout.

So what do you do about this? No, the point isn’t what you do, but whether you understand what’s going on. If your stock’s price moves a great deal intraday but not a lot by the close, there’s a reasonable chance that traders are engaged in relative value arbitrage. And simply having that answer when the CFO stops you in the hall may be the most important thing for now.

Speaking of power outages, starting April 22 equity markets developed voltage problems. IR professionals, we’ve got two words for when you meet the CFO in the hallway and she asks, “What’s up with the stock market?”

Risk Management. What two words did you think we were going to offer? “Risk Management” is why the same stocks that were up yesterday can be down today. We saw surging European and Asian inflows April 22, and a reversal of the same inflows on April 27.

From the IR chair, it’s flummoxing. Your nearest peer, in the same industry, about the same market cap, doing similar things, reports results on April 22 and beats expectations and soars 10% in a day. You then report the same good results almost pound-for-pound, a handy beat. And your stock declines three percent.

What gives?

Time for those two words: “Risk Management.” Large portfolio trading schemes such as pension and investment funds may hold an array of securities. Let’s say euro-zone bonds, currency futures, US Treasuries and US growth stocks. Suppose these investments are protected with risk metrics software from SAS, and trading-desk level systems from prime brokers JP Morgan and Deutsche Bank. These systems are designed to monitor and maintain portfolio risk and return within certain parameters.

Greece’s bailout is approved. The systems determine that this will strengthen the US dollar, thus weakening inflows to US equities from European and Asian sources. The systems themselves execute automated trades, complete with offsetting derivatives, to control risk.

This behavior causes a domino effect. The same securities the system said to buy last week are now the ones it sells. That triggers other limit orders and stop-losses, changes the nature and size of passive market-making trades, and attracts statistical arbitragers finding fleeting imbalances. And because ONE variable in the overall risk-management schematic is different – maybe a risk metric is the ratio of dollars on reserve at the European Central Bank, which has just returned a bundle of them to the US Federal Reserve – it over-corrects.

The next day, the system tries to rebalance the overcorrection, producing a spike in US securities again. Commentators bray about renewed enthusiasm for US economic growth, which in fact plays almost no role. Leveraged ETFs had just today adapted to yesterday’s big risk-management change. Now those are out of balance.

Suddenly, inefficiencies abound. Passive market-making systems aren’t getting liquidity to the right spots fast enough. Stat arbs are executing simultaneous offsetting trades in ten different market centers, creating the illusion of movement where none exists.

And the next day, the risk-management system tries to rebalance again.

This is how you get great volatility in markets designed to function smoothly and efficiently.

You don’t need to explain it in detail to your CFO. But you should be able to say, “We have integrated global markets. Our results, which were great for our active investors, now are secondary to global risk management. That’s the reason we’re under pressure. It’s a portfolio problem.”

But portfolio problems are our problems too. What’s the answer? We invite your suggestions. Meantime, be sure management doesn’t take it personally. It’s not always about you.

Remember that Redford flick from the 1970s, Three Days of the Condor? It’s a thriller about high-level conspiracy. In volatility trading, an Iron Condor is not conspiratorial, just an income trade. You sell two puts and buy two calls, with the spread between both always giving you an initial credit in your account (your highest possible return). If the underlying issue, say an individual stock or the S&P 500 Index, the SPX, trades between your puts and calls, your options expire and you keep one or both credit spreads. It’s a popular thing to do in sideways markets.

Since the SPX converted Dec 24 from the June 2009 version to the next iteration of the S&P 500 Index (it’s called the SPX converting to the SPL), the three days before that might’ve been a deliberate effort to put a squeeze on some Iron Condor traders. Why? Quiet markets. No news is good news if you’re trading for a credit profit. Money’s on the sidelines.

Instead, the “Vega,” or unexpected volatility, increased. Was it chance, or did counterparties take advantage of the situation and push some Iron Condors into the money, forcing them to cover and pay rather than keep their credits? It’s possible. Also, Iron Condor is a pretty good name for a rock band.

Now, why would you care about Iron Condors, IROs and execs? Because once again something besides fundamentals affected market prices. The cool, contemporary and confident IRO has got to know market structure. If you thought it mattered in 2009, wait till you see the variables lined up to hit the 2010 markets.

Here’s one. If you wanted a swear word this past year that reflected something infinitely venal, you would mutter sharply, “auction rate securities.” Yesterday, the Federal Reserve announced that it would offer term deposits to banks through periodic auctions to try to bleed some of the $1-2 trillion of excess, created cash out of the system.

In the private sector, manufacturing an artificial means to deal with excess cash is called “money laundering.” But the Federal Reserve is counting on banks to park cash with them at your expense next year, since interest will be paid on these manufactured deposits.

The point is, what happens if banks use the new government auction-rate market instead of trading with that excess cash as they did in 2009? We don’t know. It’s a Vega Risk. Vega risks abound.

We actually think 2010 could be a ripper of a year in equities, at least for awhile. Why? It’s less risky to trade with money than to loan it into economies dictated by regulations and monetary policy. Loaning requires a term and performance by another party. Trading you can do any given day and end flat, and you can take advantage of what other people do, instead of depending on them. Maybe with some laddered Iron Condors.

Wry humor to end 2009! Have a fantastic New Year, and we’ll have more to say in 2010.