Options may be a relatively obscurity even to veteran investors,
but the concept behind them actually dates back to around 600
Thales of Miletus, a father of Greek philosophy, is credited by
some accounts for the first use of options for financial gain.
After forecasting a bountiful harvest because of good weather, the
story goes, he bought all the olive presses in the ancient coastal
city of Miletus, thereby cornering the market.
Thousands of centuries later, modern-day money managers may finally
be learning his lesson. Although options have been growing in
popularity for more than three decades, they have yet to gain
widespread acceptance. But the May 6 market crash may be changing
that in a big way.
Take Joe Clark, for example, who overseas $180 million in assets
across hundreds of client portfolios at Financial Enhancement
For years the Indianapolis-based money manager has relied on
traditional methods for protecting clients' portfolios, such as
raising cash when the market rallies and allocating capital to
lower-risk bond investments. Now he may add another layer of
security using options as insurance.
"You're better off owning the puts at this point than trying to use
stop-loss orders," Clark said a few days after the crash, because
those option contracts allow an investor to sell a stock for a
pre-determined price even if it has fallen far below that level.
"We are exploring options to increase our use."
Unlike simple stop-loss orders, under which a stock is simply
sold if it falls to a certain level, puts can serve as insurance
contracts held in portfolios alongside stocks. Because their values
rise when shares fall, they can be used to offset losses keep
investors from selling their stocks at rock-bottom prices.
If there ever was a day when this mattered, it was Thursday, May 6,
when the market returned to its most volatile conditions since the
mortgage-fueled crash of late 2008. The S&P 500 swung a wild
102 points, its third-biggest move ever, as blue-chip
multinationals made price moves typically seen in small high-risk
Procter & Gamble, for instance, lost more than a third of its
value at one point--possibly because of a data-entry mistake--while
other names such as 3M and Hewlett-Packard fluctuated by as much as
21 percent and 18 percent, respectively.
Transactions were recorded at hugely different prices amid the
volatility, causing thousands of orders to be canceled and
triggering investigations by Congress and the Securities and
"We were verging on having financial markets become dysfunctional,
driving the fundamentals as opposed to reflecting the
fundamentals." said Jim Paulsen, who oversees $375 billion of
assets at Wells Capital Management in Minnesota. Even though Wells
didn't have problems with execution, he said, "if it keeps up in
that regard, you would be looking for ways to deal with it."
Paulsen said he would consider using an important option-related
product to manage risk: the VIX. Known formally as the CBOE
Volatility Index and informally as the "fear index," the VIX is a
high-octane hedging vehicle whose popularity has boomed since the
2008 financial crisis.
The VIX measures the cost of protecting a broad-market portfolio
against a general crash. When investors use traditional puts, they
must select a certain price level to buy insurance. The problem is
that if they buy puts and then the S&P rallies 10 percent, they
must surrender all of those gains before the options kick in.
By contrast, the VIX usually drifts in a range even as stocks climb
and then explodes higher on market declines. In the week leading up
to the May 6 selloff, for instance, it surged by more than 125
percent even though the S&P fell by no more than 12 percent
over that same period.
"When outliers happen, the VIX goes up so fast," said Larry
McMillan, the president of McMillan Analysis Group and an author of
best-selling books on the use of options. "You don't have to spend
a lot for protection."
McMillan believes that more traditional institutional investors are
looking to use the VIX as a regular hedging mechanism for their
portfolios. He said the best strategy is to buy call options on the
VIX when volatility is low, which provides major leverage if a
One popular strategy is the so-called vertical spread. In a
hypothetical trade with the VIX at $25.15, an investor would buy
100 contracts of the June 27.50 calls for $2.85 and sell 100
contracts of June 30 calls for $2.15. That would translate into a
net cost of $0.70 per call contract owned. If the market tumbles
and the VIX pops over $30, they'll collect $2.50 per contract--a
257 percent gain.
"We use options to protect when the VIX is really low because the
protection is cheaper when you don't need it," said Alan Lancz,
president of Toledo, Ohio-based Alan B. Lancz & Associates. He
also expects more institutional investors will use options as a
hedging tool after last week's selloff.
Jim Gocke, head of institutional research and investigation for the
Options Industry Council trade group, predicts that the committees
running endowments and pension funds across the country will start
considering options to manage risk.
"They're saying, 'It's insufficient for us to count on a
diversified portfolio,'" Gocke said. The May 6 selloff "will
resurrect the idea we need to do more," he predicted.
Jamie Tyrrell of Group One Trading is already seeing the pickup on
the floor of the CBOE, where he's the primary market maker for VIX
"We're seeing more daily volume, seeing more orders and seeing more
bodies in the pit," Tyrrell said. "There are a lot of brokers in
the pit who don't have enough spots who just stand behind it. It's
pretty clear there are a lot more people playing now than in 2007
(Stock chart courtesy of tradeMONSTER; VIX chart courtesy of
Chicago Board Options Exchange)