The options industry is growing, and over the next few years more institutional investors will seek to invest in them to diversify portfolios and lower risk.
An option is the right for a buyer to buy or sell an asset at a set price on or before a given date. Options are types of derivatives, which means they obtain their worth from the value of an underlying investment. An option that gives the buyer a right to buy is a call option. An option that gives a right to sell is a put option.
Institutional investors may have shied away from options, but now many more are implementing them in their portfolios, said Philip Gocke, managing director of the Chicago-based Options Industry Council. They offer a limited downside and more leverage than a straight equity position, he noted.
Nearly $2 billion was invested in options last year, and Gocke estimates that half of the money came from institutional investors, including hedge funds, pension funds and endowments.
As new money managers enter the business, it will inspire some companies to take different approaches and possibly look into the options market more, commented Denise Valentine, an analyst at Boston-based Celent.
Hedge funds are using options in a sophisticated manner and are the fastest-growing segment of institutional investors using options, said Peter Lawler, head of institutional development at Chicago-based OptionsHouse. As volume has grown, the market is seeing increased liquidity as well, he commented, further compounding hedge funds' interest in the instruments.
Another factor contributing to the industry's growth is penny pricing, which allows options to be traded at a penny, instead of a nickel, Lawler said. A number of exchanges are currently test piloting this pricing model, he said.
Also, the Securities and Exchange Commission has approved a new portfolio margining rule. Effective April 2, it will allow broker/dealer customers at the New York Stock Exchange and the Chicago Board Options Exchange to include equities, options and other unlisted derivatives in the same account. This will allow hedge funds to be margined on a more realistic basis, Lawler said.
The expanded portfolio margining rule for options could mean significant savings for clients, such as hedge funds. Under current New York Stock Exchange rules, an investor must put 50% into a margin account the first day equities are purchased, with the requirement dropping to 25% the following day. On April 2, the requirement will drop to 15% starting the first day.
Interestingly, retail investors drove the initial interest in options, Gocke said. While institutional investors' options trades now dwarf those of retail investors, individual investors will continue to place money in the instruments, he predicted.
"It depends on the level of education and understanding, but once achieved, options can supplement [retail] investors' objectives for their portfolio," said John Hass, co-chief executive officer at OptionsHouse.
A recent study on options proves the point they offer high returns. Called "Risk and Return Characteristics of the Buy-Write Strategy on the Russell 2000 Index," the study was conducted by the Isenberg School of Management's Center for International Securities and Derivatives Markets at the University of Massachusetts. The Options Industry Council, which sponsored the study, is funded by the American Stock Exchange, Boston Options Exchange, Chicago Board Options Exchange, International Securities Exchange, NYSE Arca, Philadelphia Stock Exchange and the Options Clearing Corp.
A buy-write strategy involves writing a call option on an equity index against a long position-where the number of contracts bought exceed the number of contracts sold-in the same underlying equity index. The strategy is usually performed passively without market timing.
Examining data from January 1996 to November 2006, the study found that a passive buy-write strategy on the Russell 2000 Index with a one month expiration date has consistently outperformed the Russell 2000 Index on a risk-adjusted basis. This also takes into account when performance is evaluated using standard measures, the report states.
Over the 10-year period, the passive buy-write strategy on the Russell 2000 Index had an annualized return of 10.67%, while the annualized return for the at-the-money buy-write, which is when an option's strike price is equal to the market price of the underlying security, returned 9.21%. However, the at-the-money strategy yielded lower annualized volatility of 13.36% compared to 20.52% of the passive approach.
The study also evaluated options during poor market conditions for the buy-write strategy, specifically from February 2003 to November 2006, when the Russell 2000 Index experienced high sustained growth at relatively low volatility. Over the period, the Russell 2000 had an annualized return of 24.82% and a volatility of 15.34%. The buy-write strategy easily outperformed the Russell 2000 by standard measures, returning two-thirds of the index's return at half its volatility, the report found.
Previous studies have repeatedly found that the buy-write strategy on the S&P 500 outperformed the S&P 500 on a risk-adjusted basis. Going forward, the Options Industry Council will study buy-write strategies compared to the Nasdaq 100 and other indexes as well, Gocke said.
Also, in conjunction with the report, in an effort to further educate institutional investors, the Options Industry Council has launched a website for options information and education geared toward institutional investors. The site, oicoptions.com, includes research articles, online classes for all levels, as well as interactive tools such as Position Simulator, which allows investors to explore positions using real market conditions.
(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.