12:33 PM
Options: The Line Between Institutional and Retail Trading
A perfect storm is about to hit the options market. Trading volume is reaching record levels seemingly on a monthly basis. Volatility—a critical component of any options trade—is flirting with historical highs and the resulting stock market gyrations seem to be the focus of every morning, noon and evening talk show. Regulatory initiatives and new technologies are changing the way options are being traded, resulting in greater demand from institutional investors and shining even more light on the potentialities of options. -- TABB report: Equity Options Trading 2008
So the sophisticated institutional money has finally caught on to what many retail investors have known for years--mainly, that options can provide excellent opportunities to hedge portfolio risk, enhance potential portfolio returns and help enable more prudent use of capital. From our view, there are three major drivers behind the institutional push into options:
- Low interest rates are forcing managers to expand into new products to find extra returns
- Large fund losses accentuate use of options as a portfolio hedge
- Investment capital is harder to come by, so managers need to use capital more efficiently
Institutional Options Interest Places Premium on Execution
First of all, let’s be clear. The institution, whether a hedge fund, pension fund, high net worth individual, insurance company, closed end fund, etc., needs to understand execution and be able to measure its broker’s effectiveness in achieving best execution. This is especially true since some of the hallmarks of institutional market participation – higher volumes of specific strategies, hedging strategies against broader risks, etc. – put new and significant demands on some of the established, trader-based options strategies.
Driving strong execution starts with an understanding of the marketplace. Ask the following:
- What option products are you trading? Indexes? Liquid ETFs? Top tier equities? Less liquid options?
- What size trade will you execute relative to the quoted market size?
- What is the quoted spread width of the NBBO (National Best Bid and Offer)?
- What type of strategy are you utilizing? Spread? Buy/write? Outright purchase or sale?
- How aggressive is your strategy? Are you looking for volatility or delta opportunities or putting on a longer term position?
These are just a few of the questions that you need to ask yourself and then discuss with your broker. See how your broker responds to gauge their level of expertise in execution. You need to be confident that your broker understands and takes the execution of every trade seriously. The answers to the above questions clearly should impact the method used to execute the trade.
Let’s take a look at a few common but hypothetical examples from the optionsXpress Institutional desk this week.
Tactical Use of an Option Block to Offset Short-Term Downside Risk
Customer A has allocated $6 million to equities in the technology sector. She has enjoyed a nice run up with the market recently of over 25% and is looking to rebalance and take some profits. She is sifting through her research and making some decisions, but realizes there are a slew of earnings reports coming out this week. She needs to hedge quickly against what she fears might be a sharp pullback in the market off of the highs before she can make the equity adjustments. She knows her portfolio tracks the QQQQ—the technology heavy NASDAQ 100 Tracking ETF and she knows options on QQQQ are some of the most liquid available. She anticipates holding the hedge for less than a week, so is willing to buy a put with some time premium in it. She notices the Sept 41 put is offered at $1.88 with enough size to establish her hedge. With the market .02 wide and her desire to get the hedge on immediately, she makes the decision to point and click and purchase 2000 @ $1.88. Her order sweeps the seven exchanges and she receives an immediate fill.
QQQQ Sept 41 put—with the QQQQ trading $39.37
Customer B manages several accounts and is an active seller of out of the money index call spreads against his clients’ equity portfolios. He likes options on the RUT---Russell 2000 Index . He has a short-term bearish view and is looking to write calls at 590 and buy calls at 600 in September with the index at $558.55. He sees on the quote page that the NBBO quote is bid at $.95, but his online broker’s portal has an indicated buyer at $1.00. He has 10,000 contracts to sell across several accounts, and he understands that RUT spread markets often trade between the electronic quotes. He calls the execution desk and asks them to quote the market directly from the liquidity providers and gives them an order to sell 10,000 contracts at $1.05. The desk is able to locate a $1.05 bid and the customer is given verbal confirmation. The trade is immediately processed in the customer accounts.
RUT = 558.55
Off-Floor Liquidity to Address Mismatches Between Trade Strategy and Exchange Demand
Mismatches between trade strategy and market interest sometimes occur, and will become more frequent as institutional investors and wealth managers actively embrace options. This is where newer execution strategies can be most crucial.
Customer C has a large equity position and is looking to collar the position with options in 2010. April is the last month listed (no leaps) and the customer does not want to request leaps be added. The options are only listed on two exchanges and the quoted widths are wide. After discussion with the customer, it is decided that the April 20put/30 call collar is the desired trade with a price target of $.50 credit for 5000 contracts. As shown below, his online broker’s liquidity does not show interest in this trade and a review of open interest reveals 5000 contracts is 2x the highest interest in any strike listed. The customer understands the liquidity concerns and agrees to work the order over the next few days.
Execution contacts the assigned liquidity provider (DPM) at the CBOE and asks for a two-sided market in the collar, so as to not tip the customer’s hand. At the same time, the execution desk calls off-floor liquidity for a market. Again, there is little interest as this product rarely trades. The DPM at CBOE eventually shows a $.50 bid for 500 contracts and the desk executes the trade. Over the next few days, the desk is shown $.50 bids from the floor in pieces and executes as they are shown. At the same time, the volume on the tape raises the interest of other off-floor liquidity and the bids come in more frequently. By the fourth day, all 5000 contracts are completed.
WXYZ—Apr 2010 20 put/30 call collar without stock, WXYZ = $25.80
The goal is always to maximize the execution experience. Each order is another opportunity for the broker to achieve best execution. The institution should have dialogue with their broker about the execution process on a regular basis. They need to review all of the above as the strategy, goals, and market structure may have changed. The path to execution should be responsive to those changes
Options involve risk and are not suitable for all investors. Please read "Characteristics and Risks of Standardized Options" or also available by calling 1-888-280-8020.
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