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The Rush to Alternative Investments

Extreme volatility and macroeconomic uncertainty are driving the buy side into alternative investments. But firms are using options to boost returns, not just hedge positions.

With volatility resurfacing and fears about the stability of the global economy persisting, institutional and retail traders alike have been turning to alternative investments as ways to cope with the anxiety and uncertainty in the markets. While the popularity of alternative asset classes, ranging from equity options to currency and gold futures, has been growing for several years, participation in alternatives among asset managers and retail investors has skyrocketed this year as traders have sought to cushion their portfolios against the zigzagging stock market or, conversely, to make bets on the volatility.

Wild intraday swings in the U.S. stock market have driven institutional traders and retail investors to hedge their positions with listed derivatives to protect themselves against sudden market plunges. As anxiety rose this summer, options trading volumes reached a record high in August. According to data from the Options Clearing Corp., which clears trades for all nine U.S. options exchanges, more than 554 million contracts were bought and sold in August 2011, representing a 94 percent increase from August 2010's 283 million contracts.

"In September 2008, a month before Lehman went bankrupt, we had huge volatility, but we didn't see this kind of volume," recalls Jim Binder, a spokesman for the OCC who attributes the heavy options volume to the influx of both institutions and retail traders. When institutions saw the indices drop nearly 40 percent during the financial crisis, they discovered the risk management potential of options and entered the market head first, he explains.

The uncertainty generated by the political gridlock in Washington over the U.S. debt ceiling, Standard & Poor's downgrade of U.S. Treasuries' triple-A credit rating and concern about the ongoing European debt crisis also contributed to the heavy move to alternatives, which is reflected in the price of gold futures (gold established a new high of $1,923 a troy ounce during the first week of September). According to John Netto, president and founder of M3 Capital in New York, the macroeconomic situation is the No. 1 reason alternative investments have become more popular.

Traders are moving into alternative investments because of the increased volatility in the equity markets, says Netto, an index options trader who focuses on global currencies and precious metals. "People are concerned about sovereign debt and the debasement of the currencies," he says. "There's more participation in this space by necessity."

Plunging stock prices pushed up the CBOE's Market Volatility Index (VIX), known as the "fear gauge," past 39 in early September; while this still was far lower than the 80 seen during the 2008 financial crisis, "It had doubled over the past three months," points out Netto. As a global macro trader, Netto says he looks at the index options where there are opportunities. "I trade fixed income, metals, energy -- I like to compare volatility across all those asset classes," he reports.

In Search of Higher Returns

But volatility is only part of the story. Investment managers are turning to equity options, index options and even options on ETFs not only to hedge their portfolios, but also to boost returns in a low-return environment. "People are realizing that 'buy and hold' doesn't cut it anymore," comments Stephen Davenport, director of risk management, investment management, at Wilmington Trust in Atlanta. "And so we need to be more aware of risk tolerance and try to be more active in mitigating risks when clients require it, and listed options are one of the best ways to do it."

Noting that many of Wilmington's clients want the firm to generate income from their positions, Davenport says he uses a simple options strategy -- selling call options and buying put options. "I sell calls to generate premium and I buy puts to hedge [client exposures]," he explains. In an environment in which stocks may be earning just 6 or 7 percent, Davenport adds, investors are going to be excited about adding 1-1.4 percent with options.

According to Davenport, he uses Bloomberg to obtain real-time prices, and he compares those to what he determines, using proprietary algorithms, should be the correct price of the options contract -- given the level of volatility and the current price level. "I use some formulas and strategies to try and determine how many contracts I should put on over what time periods, and how to manage my exposure," he relates.

Davenport adds that the use and proliferation of options has been explosive. "The whole options business has changed just in the five years I've been managing them here," he asserts. "Five years ago there were nickel spreads and no dollar strikes; now there are penny spreads, dollar strikes and higher-priced strikes."

In addition, new weekly options have added more volume to the market as well, notes Davenport, citing this as an example of how the options industry continues to innovate and come up with new ways to take off exposures. "It's really replacing many of the OTC instruments that have dried up," he says. "We're starting to see people say, 'I'm going to try to do it with listed options.'" Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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