Money managers turn to options

By David Russell,

Shutterstock photo

Options may be a relatively obscurity even to veteran investors, but the concept behind them actually dates back to around 600 B.C.

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.

Thales of Miletus 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 Group.

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.

PG Chart 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 companies.

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 Exchange Commission.

"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.

VIX Chart "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 selloff occurs.

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 options.

"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 through 2009."

(Stock chart courtesy of tradeMONSTER; VIX chart courtesy of Chicago Board Options Exchange)

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Copyright © 2010 OptionMonster® Holdings, Inc. All Rights Reserved.

This article appears in: Investing Options
Referenced Stocks: HPQ , MMM , PG , SPX , VIX

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