Institutional trading is the main driver behind the continued surge in options volume, and, as with other asset classes, it is hedge funds doing most of the trading. Looking at options trading over the last 10 years, one notices the dramatic shift in the industry’s customer base, says a recent report from Aite Group, a Boston-based financial services and technology consultancy. In 1997, 80 percent of total options volume came from retail investors. Today, Aite Group reports, slightly more than half-54 percent-of trading comes from institutions.
The Aite report goes on to say that three forces have “entirely changed the players and the profits” in the options market: an evolving regulatory regime, the advent of electronic trading and the consequent institutionalization of its customer base. To be sure, it was the competition created by the Securities and Exchange Commission requiring multiple listing of options that helped to increase liquidity, giving institutional traders the ability to execute complex options strategies with little market impact. Electronic trading gave them the tools to execute with one click of a button, making it easier to get in and out of large positions.
Goes Pop
A shift in attitudes toward using options began within the institutional trading community after the tech bubble burst in 2000, says Phil Gocke, managing director of institutional research at the Options Industry Council (OIC). These investors realized they needed to protect their portfolios against a downturn, he says. “Options became a desirable method for establishing exposure or protecting against market declines on long-only stock positions,” he says.
The surge in options volume stems, in part, from pension funds and endowments shifting to alternative investments in their attempt to gain outsize returns and to diversify investment strategies. Alternative investments could comprise 5 to 15 percent of a pension fund’s assets, Gocke says.
For example, Harvard and Yale endowments, with billions of dollars in their portfolios, invest with hedge funds, says Randy Frederick, director of derivatives at Charles Schwab.
The Users
Mutual funds are more tightly controlled. They just dip their toes into options compared to hedge funds,” Frederick says. Mutual funds will sometimes have restrictions that don’t permit the use of options.
Besides independent hedge funds, the proprietary trading desks at the large investment banks are also large consumers of options on the institutional side of the equation. Options trading is particularly well suited to hedge fund-type strategies, which give these investors the ability to be exposed to both the long and short sides of the market.
Andrew Wilkinson, a senior market analyst at Interactive Brokers, points to an industry study showing that 92 percent of all options are traded in an attempt to hedge a position. Among the options that get the most action are the ones related to three popular exchange-traded funds: the Nasdaq 100, the S&P 500 and the Russell 2000. Both the Russell 2000 and the Nasdaq 100 options trade more than 800,000 contracts a day, while the S&P 500 option trades about 500,000 contracts a day.
“There’s just been an explosion in those ETF options,” Wilkinson says. “Spreads are narrow, trading costs are down, and trading volumes are through the roof. There’s a tremendous amount of liquidity in those options.”
Puts Big Winner
Most of the strategies behind these options purchases appear to be about protection on the downside of the market, he explains. Both the S&P 500 and the Russell 2000 trade more puts than calls, at a 2-to-1 ratio, Wilkinson says. The lean toward the puts is more dramatic with the Nasdaq 100, with a 2.7-to-1 put-to-call ratio, he says. “These are efficient hedging tools for long-only money managers to protect their portfolios from downside risk,” Wilkinson adds.
“Across the board, we see volume growing in put options,” agrees Frederick. “The market is very shaky right now. We’re in a four-and-a-half-year-plus bull market, and when you have had a bull market, it makes sense to acquire put options, so you don’t get clobbered if the market gets clobbered,” he says.
“It also keeps the market from going down too badly, because what makes the market go down is when investors start selling,” Frederick says. “If people have puts to protect themselves, they don’t panic-sell.”
Outside of hedging strategies, two well-known types of trades have also added to the volume in the last several quarters, according to Wilkinson: dividend capture plays and put interest plays.
In the former, say a stock trades about 30,000 to 40,000 options contracts per day. When the stock goes ex-dividend, those who own deep-in-the-money calls need to exercise the calls to receive the dividend or lose it. This dividend capture play allows market makers to get together and sell deep in-the-money calls, aiming to shake out the retail open interest in the hope that some forget to exercise their call options. The same thing happens on the put options.
In a put interest play, if a stock falls from $70 to $50 and there were existing put holders at the 70 strike, those puts are now deep in-the-money. So hedge funds or other investors can sell those puts, go long the stock and try to hold it for three or four days, essentially “renting out” their long stock on a daily basis, earning interest.
The break-even point is three or four days. There is a risk of being assigned the stock, but it is slim, Wilkinson says.
More Capital
Covered calls, or buy-write strategies (going long a stock and writing a call option), such as one on the Russell 2000 index, are employed much more aggressively and dynamically by hedge funds or open and closed funds, says the OIC’s Gocke. “Between $25 and $30 billion worth of new open- and closed-end funds employing buy-write strategies have been listed in the last two years. It’s a big volume driver.”
According to the Aite report, volatility strategies such as options on the VIX index are particularly popular with hedge funds and other investors. Capital dedicated to volatility strategies grew by two-thirds in 2006 and 150 percent over the last three years. According to one Chicago options trader, hedge funds like using volatility strategies in options as opposed to equities because the volatility return is greater in the options market, since volatility is a crucial part of an options contract.
One options trader says hedge funds are starting to incorporate forward pricing models into their options trading strategies. In a forward model, algorithmic traders use the market data on a stock to write a program that predicts the probability of the future price it may trade at in the near future.
But it must be in the very near future-15 seconds or less-to be accurate. This has been a common strategy in the equities markets, and traders are now blending that with options. The increased speed of available technology has enabled algorithms to execute these trades rapidly, by spraying the exchanges with orders until they get filled.
As technologies such as smart order routing and algorithmic execution keep improving, the tremendous growth in institutional trading of options is likely to continue, according to the Aite report.
Trends
Regulatory changes, the introduction of portfolio margining, the consolidation of options exchanges into larger multi-asset exchanges, and the continued growth of OTC volatility products should all support this trend as well, the report says.
The industry watchers who spoke with Traders Magazine mostly echoed that optimism. So will traders increase their use of puts and other hedging strategies if the bull market continues?
“Investors have come to believe that long equity portfolios are always the best strategy,” Gocke says. “But you need to take positions that keep you from panicking during a market down draft, and options are a way to manage your portfolio so you don’t panic. There has been a significant amount of put buying in the last month.”
