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February 1, 2005

On Top of the Options Craze

By Mark Longo

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Welcome to Tuesday morning hell. The stock is tanking after the company has cut its earnings estimate. There goes your year-end bonus. So, you fire up the trading screens and scan for bids in the stock. No luck. The guy next to you pounds his keyboard, but the bids don't come. He's glancing nervously at a family photo. It looks like junior's going to state school next year. Oh, brother.

Then you scan Instinet, scrambling for a way out of this mess. That's when inspiration strikes. With a click of the mouse, up pops the International Securities Exchange (ISE). Suddenly, here it is. A hundred lot of puts sitting in the book. You click the buy button. But time slows to a crawl as the puts disappear from your screen. Your heart sinks. Someone must have beaten you to them. You close your eyes and take a deep breath. A scream is building up until the soft beep of an order confirmation hits your system. Brilliant. Leaning back in your chair, you chuckle softly. The pro beside you immediately wraps you in a bear hug. Options saved the day. Junior is going to Harvard after all.

Buyside Traders

This story is not about being lucky in trading. This is a story about a transformation in institutional equity options from an instrument for a narrow group to an instrument for the mainstream masses. Once portfolio managers and buyside traders would only trade exclusively in stocks. Today, on many stock trading desks beside the Instinet screens, for instance, are the latest quotes from the options markets.

Sure, some equity traders have dabbled in options for decades. However, until recently, most viewed options as the domain of speculators and shadowy hedge funds. But with options volume exploding over the past five years [see chart], this view is changing. Today, as one exchange official explains, more institutional investors - from private asset managers to mutual funds - use options to hedge their positions and improve returns. The retail market is also promising.

"Options are popular because of their flexibility. They are the most versatile investment tool that exists for equity traders," says Bill Brodsky, Chairman and CEO of the Chicago Board Options Exchange (CBOE). "You can trade them with the stock, without the stock or around the stock. Stock for stock, the liquidity in the options is much greater than it is in the stock." But how, in practice, does that help the buyside? Since many buyside equity traders are restricted to long positions, options are a useful tool for hedging risk and taking profits without having to liquidate positions. The most popular option traded on equity desks is covered call writing. This simple trade consists of selling a call against an existing equity position. One trading official says the protection is critical in winning points with clients.

"Writing covered calls is definitely our most common option trade," says Kevin Connellan, director of equity trading at Northern Trust in Chicago. "We primarily use options to get a few more basis points for clients. Most of the time that involves going long in a particular stock and then writing a call against it."