Institutions Warm Up to Options

Options trading is being increasingly used by institutions to manage achieve higher-risk-adjusted returns, Matthew Moran, vice president at Chicago Board Options Exchange, said at Thursday's Global Markets Summit.

“Volatility tends to go up in times of market crisis, such as 2008, when the CBOE Volatility Index (VIX) hit an all-time high of 80.86,” said Moran. “Institutions can use options to capture returns from higher volatility.”

In fact, volatility was one of the few asset classes that had low correlation to the S&P 500 in 2008, along with the VIX Short Term Futures Index, managed futures, and gold.

By selling, or writing, options, institutions can benefit from the fact that most options expire worthless at expiration, benefiting the seller. “Implied volatility is higher than realized volatility,” said Moran. “By selling options you take in a lot of premium which makes the strategy profitable.”

The addition of the CBOE S&P 500 Buy/Write Index (BXM) to a diversified investor portfolio would have generated significant improvement in risk-adjusted performance over an 18 year period, Moran said, citing various studies.

A buy-write strategy, also known as a covered call, involves buying a stock or a basket of stocks and writing call options that cover the stock position. The option premium received cushions downside moves in an equity portfolio. Therefore, the buy- write strategy may be expected to outperform stocks in bear markets and under perform stocks in bull markets.

Still, it's a tough sell to get pension, foundation and endowment trustees to take a look at options, primarily because of their complexity. That's being addressed partially through education. “A pension plan sponsor will only consider an options strategy if their consultant approves it,” said Moran, “so you have to sell both the plan sponsor and the consultant.”

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Posted on Dec. 4, 2009