NEW YORK Options are gaining endorsements from institutional investors all too familiar with the steep losses their long-only stock positions sustained after the Nasdaq bubble burst.
A new study by consultant TABB Group LLC, New York, found that institutional managers are increasingly using options in sophisticated portfolio strategies to protect or enhance alpha-generating opportunities.
A perfect storm is about to hit the options market, TABB analysts Andy Nybo and Kevin McPartland wrote in the study, released in late February. Trading volume is reaching record levels seemingly on a monthly basis. Volatility a critical component of any options trade is flirting with historical highs.
In the study, TABB Group estimates that one-third of institutional investors are actively using options in portfolio strategies today.
Gary Katz, chief executive officer of the International Securities Exchange, New York, the worlds largest equity options market, said in an interview that institutional flow accounted for half of the 726 million contracts his exchange handled last year.
Other industry sources put the percentage of institutional flow at close to 60%. Those sources said only new large liquidity providers, such as institutional portfolios, could account for the near quadrupling of options volumes over the past five years: 2.86 billion contracts traded in 2007 vs. 780 million contracts in 2002.
The volatility we have seen in the financial markets over the past months has been a big contributor to the record volumes weve seen in options markets, TABBs Mr. Nybo said in an interview.
Investors and hedge funds asset managers and to some extent fiduciaries are looking for ways to both exploit and hedge against the volatility. They have strategies that can leverage that volatility, and so, they are more active in these marketplaces and thats why you see greater options volumes, Mr. Nybo said. What is relatively new here is the appetite for these types of strategies by asset managers strategies they may not have explored in the past.
One factor supporting the explosion of trading volume is that options are no longer viewed as a financial flea market where the naïve and uninitiated speculators attempted to get rich overnight, according to the TABB study, adding that options can no longer be viewed or portrayed as remotely speculative.
While hedge funds readily endorsed options strategies, conservative public pension funds, traditionally adverse to using derivatives, are cautiously entering the field and are allowing options to be used in externally managed accounts, the study said.
I have always felt that options were a very valuable and versatile tool to have in your arsenal. Current data indicate that a lot of people are starting to feel the same way, Richard Cancelmo, investment manager at Bridgeway Capital Management Inc., Houston, said in an interview. Bridgeway has $6.2 billion in assets under management as of Dec. 31, mostly in equities.
We use a couple of strategies, such as the standard covered call. Certainly, there is more volatility in todays market and that means there are greater premiums. But options are versatile investment tools. In a lot of cases, you know the risk/reward to the penny and the influx of electronic trading has certainly helped more people take advantage of options, Mr. Cancelmo added.
Standard covered-call writing involves the simultaneous purchase of stock and the sale of a call option.
The TABB study said that technology, which the ISE promoted in the options world as the first U.S. electronic options exchange, has played a key role in attracting institutional order flow. But this may only be the beginning: TABB analysts expect the same sophisticated tools found today in the equity world will gain acceptance in the options realm.
Algorithms are also beginning to see rapid adoption, and based on our research, more than one-third of total volume will be traded algorithmically by 2010, the TABB study predicted. This will provide a strong boost to overall volume levels and raise overall liquidity.