The common element among these trading firms was their understanding of risk. They were mainly concerned with the vagaries of option prices. They all understood one thing: When investors underestimate risk (or potential risk), they sell options too cheaply; when they overestimate risk, they pay too much for them.

They used to their advantage by employing proper amounts of leverage to earn “spreads” between option prices. These firms branched out into other strategies where this concept of estimating and pricing risk (volatility) was paramount in generating returns: Convertible bonds, risk-arbitrage, and even long/short equity.

Dealers like Morgan Stanley also run these same strategies, and can themselves be considered a special type of hedge fund (they comparatively use a lot of leverage). Many of today’s hedge fund managers used to work for these dealers and employ the same strategies they used when facilitating customer trades.

For example, a long/short equity hedge fund closely resembles block trading at sell-side dealers. The first long/short stock hedge fund -- Battery March, founded by Dean LeBaron -- was a huge customer of the block business in the early 1980s, and often took the other side of those customer trades facilitated by a block desk.

And that leads us to try to define what a hedge fund is, or at least what it's supposed to be. A hedge fund eliminates (as far as this can be done) extraneous or superfluous risks, while isolating a set of primary risks. These risks are then analyzed for “degree and price,” and a certain amount of leverage is applied to generate a commensurate amount of return.

A long/short equity hedge fund, by selling notionally the same amount of stock as it's buying (adjusted for beta), can be said to “hedge” away market or systematic risk and isolate stock or unsystematic risk. Because they have little market risk, the manager is theoretically able to increase this amount of unsystematic risk above the level that a straight equity manager would. But the degree to which leverage can then be employed is a function of “degree and price.”

If the manager is short Motorola and long The Gap, the degree of that risk is very high, because there isn't much correlation between the two. If the historical relationship between the 2 is also low (MOT price is relatively low versus GPS on an historical spread basis), the “price” is low; because the degree of risk is high and the price of risk is low, applying any leverage may not be wise.

Other strategies where there's a high correlation between the long asset and the short asset (degree is low) and when there's a great advantage in the relative price (like when convertible bonds are very cheap theoretically) may allow higher leverage. The bottom line is this: The amount of leverage is a direct function of risk: when risk is low, leverage can be high; when risk is high, leverage should be low.

Because of 1987, investors in general realized that stocks had much more risk than they perceived. Remember there are 2 subsets of risk: Day-to-day volatility, and tail or potential volatility. Investors had been focusing on day-to-day volatility, and had forgotten about its much nastier sister. After 1987, more sophisticated investors began to actively seek out hedge funds (because they control risk) - and the industry took off.