With the bull market but a distant memory, institutional investors today must strive for every basis point of performance. Success hinges on detailed research, a disciplined methodology and using all the investment tools at one's disposal. So why is it that options - one of the most powerful and effective investment tools - continue to be underused, if not ignored, by most institutional money managers?
By combining sophisticated simulations, probabilistic and predictive modeling, extensive volatility analysis, high-end computing power and a thorough knowledge of options, it is possible to harness the power of options safely, consistently and to great effect.
Consider this: A professionally managed call writing program executed against a portfolio that tracks a benchmark, such as the Standard & Poor's 500 stock index, can reliably generate 200 to 400 basis points of outperformance, relative to the benchmark, with a reduction in overall volatility. Such performance results can be achieved in most market conditions, including a prolonged bull market, and without adding any additional risk to the portfolio.
With the market continuing to languish and the growth of passive management accelerating, we see a new trend: a shift from active management of stocks to active management of volatility through the use of options.
Options can and should be used by institutional investors to:
* create yield enhancement;
* hedge existing positions;
* reduce the effective purchase price of stocks;
* raise the effective selling price of stocks;
* create leverage for directional and volatility views on stocks or the overall market; and
* create specific return distributions to match the investor's investment objectives.
Investors can use individual equity options, index options, listed or OTC options for any of the above situations.
Useful at all three points
Options are useful at all three points in the investment cycle: entry, holding and exit. For example, while accumulating a position, writing puts on the underlying equity can reduce the effective purchase price by the "time-value premium" in the option. During the period the equity is held, volatility can be harvested by writing call options to provide yield enhancement, essentially creating a synthetic dividend. Finally, by selling calls or using certain spreading strategies to exit positions, investors can raise the effective selling price of an equity.
In each of these scenarios the amount of risk can be controlled at the inception of the trade and tailored to each investor's risk tolerance, regardless of investment philosophy. Let's take a real-world example: With IBM stock trading at $79.75 on Feb. 20, and with a predetermined exit price of $100, the portfolio manager buys a July 90-95 1-by-2 vertical call spread for 70 cents credit (buy one July 90 call for $3.30 and sell two July 95 calls for $2 each). If the stock is at $95 at expiration, the effective selling price will be $100.70, as the option spread would realize a $5.70 profit. In fact, any closing price between $90 and $95 at expiration will profit from the spread trade. If the price of the stock finishes below $90 at expiration, the investor is still better off as he or she pockets the 70 cents credit received from the spread.
Abandoned after crash
Options strategies were used widely by institutions in the 1970s and much of the '80s, but largely abandoned after the crash of 1987. In fact, index option volume has yet to recover to pre-'87 levels. The bull market also had an impact, as many institutional investors focused exclusively on equities.
Another part of the answer can be traced to the fact that options have suffered from a kind of guilt by association, having been wrongly branded as risky and complicated simply because they are a form of derivative. Options are no more dangerous or risky than any other type of investment vehicle. But they are complex and should only be used by professionals who understand their intricacies.
Beyond that, conventional wisdom has long held that option strategies, such as call writing, invariably underperform against a benchmark in a bull market. Here again, the facts tell a different story. The likelihood of underperforming can be substantially mitigated by using active volatility management. The results of this approach, which uses options based on a disciplined methodology using probabilistic and volatility modeling under the oversight of an experienced options trader, are shown in the accompanying chart. The chart shows that an actively managed call writing program on a select portfolio can outperform its benchmark with a reduction of variance, even in the bull market of the '90s.
Options should be a part of an institutional investor's toolkit. But it should come as no surprise that there is skepticism and confusion regarding the use of options and the impact on an investment portfolio. How can an institutional investor understand and use options effectively when many academics and other "experts" often disagree on how to best use options to protect, enhance and optimize a portfolio?
While that question is food for considerable armchair debate, one point is clear: By not using options to help manage portfolios, institutional investors are leaving money on the table.