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Can you buy protection?

By Margaret Elliott

Options-based protection strategies are proliferating in these queasy markets, but can you really hang on to those stock market profits?

After three years of incredible stock market performance, it is hardly surprising that protecting those gains is a high priority for U.S. investors. But if portfolio insurance was a mirage in 1987, is it any more likely that investors will be able to hang on to their profits if and when the stock market crashes again?

Given the prevalence of protective strategies involving equity options of all varieties in 1997, it seems that equity investors are willing to invest a bit of those profits in order to keep the rest. Since the market hasn't fallen like a stone—yet—and only seems a bit queasy at the moment, the jury is still out on whether protection is possible. That doesn't mean, however, that the pundits aren't arguing loudly about whether contemporary options-based protective strategies will work. They are screaming from the rooftops—from the options bears, who believe that options-writing banks are putting the entire financial system at risk, to the options bulls, who in turn think that there's a real-live two-way market in options and thus no danger at all.

Stock options of all types had a banner year in 1997, with volumes across all exchanges setting records. The Dow Jones indices were licensed for use in option products, and Robert Merton and Myron Scholes were awarded the Nobel Prize for economics for their option pricing method. All in all, it was difficult to avoid the acceptance of options in the mainstream of investing and trading.

The growth in options, mainly exchange-traded but over-the-counter as well, must be attributed to the enormous stock market gains in the United States last year. "While retail investors did join the party, the main drivers were the institutional investors, not just looking to protect their gains, but often to protect their fully invested status,” says Joanne Hill, vice president of equity derivatives research at Goldman Sachs. "They were the ones who provided most of the fuel.” And volume figures are only half the story. " If you look at the volume numbers for all kinds of options, they are just about exceeding 1987 levels,” says Michael Bickford, senior vice president in charge of derivatives marketing at the American Stock Exchange. "But open interest has almost doubled.”

For investors with strong gains in equities last year who believe that the market will continue to go up, options are a method for synthetically raising cash without actually selling stock. "In the normal course of business, most institutional investors would be looking to shift out of equities after a bull run like this, but many believe that this could be a secular shift that could go on for years,” she explains.

It is important to understand the context of 1997's options boom. Because the U.S. stock market has had such a run recently, the use of options, particularly index options, as protection had fallen off dramatically since 1993. According to statistics compiled by the Office of the Comptroller of the Currency, index option usage has actually dropped 10 percent a year on average since 1993. The reason is intuitively straightforward. If an investor buys a collar, which limits downside risk while also limiting upside potential, he or she is only really happy if the market declines. If it has gone up dramatically, as it has for the last few years, the investor who ends up giving up all that upside in the interests of protection feels a bit cheated.

What has driven the recent options boom is the growth of single stock options. The Office of the Comptroller of the Currency puts growth in these products at 20 percent in the last few years. "Another dynamic in the options market is the fact that the open interest to volume is rising,” says Goldmans Hill. "That's happening while speculative retail trading is falling off but institutional managers are flocking in.” Hill includes the high-net-worth individuals invested in stock of their own companies or in the growing number of stock-based hedge funds in this group of institutional users.

For any investor with large holdings in one company, single stock options are a real boon. "If you've received low-cost basis stock from exercising options, from a merger,” says Richard Goldsmith, managing director of equity derivatives at NatWest Securities, soon to be part of Deutsche Bank, "then you can't afford to sell the stock itself because of the capital gains implications, but you can buy a put.” Goldsmith sees plenty of activity in this area from investors, both directly and through small banks, broker/dealers and trust banks that don't have an in-house derivatives desk capable of doing the deal.

Dow Mania Hits the AMEX

Call it celebrity oneupsmanship. When the Chicago Board of Trade launched futures contracts on the Dow Jones Industrial Average, it commemorated the momentous occasion by hiring a couple of guys to put on bull and bear costumes and walk around on the trading floor carrying popcorn.

Not to be outdone, the American Stock Exchange decided to celebrate the launch of its Diamond unit trust on the Dow last month by trotting out New York City mayor Rudy Giuliani and former mayor and current AMEX board member David Dinkins. Giuliani even declared January 20 "Dow Jones Day” as he rung in trading at the exchange. This new level of promotionalism for derivatives products could easily get out of hand. What's next, Pamela Anderson ringing in silicone futures at the Merc?

The AMEX was pulling out all stops for the launch of the Diamond, which is to the Dow what its Spider (Standard and Poor's depositary receipt) product is to the S&P 500 index. The Diamond is a unit trust based on the DJIA, valued at 1/100th of the index. It offers investors a way to own the DJIA in a single equity security.

The Diamond shares most of the characteristics of the Spider, save two: Diamond dividends are paid out monthly instead of quarterly, and the fees are slightly lower—18 basis points vs. 18.5. "With the Spider, you have an accrued dividend,” says Jay Baker, vice president of derivative securities at the AMEX, "so it's paid out once a quarter. "While those dividends are accruing, they're put in a money market instrument. If the market goes up dramatically, you can't put that money back into the Spider. With the Diamond's monthly dividend, you can put your money to work faster.”

Retail investors and brokers have shown the most interest in the product early on. "I think traders will trade this because there's a futures contract at the CBOT, and there's an index option at the CBOE,” says Baker. As far as institutional use, he says, "It will be a wait-and-see. But the Diamond will be a very liquid security. I'm very optimistic. I think people want this.”

—Robert Hunter

Equity hedge funds have a difficult time finding ways to lever-up their portfolios given the nature of stock investment, but single stock options offer plenty of opportunity to buy and sell puts and calls. In effect, the entrance of this new group of users improves the liquidity in the options market, particularly in single stocks where typically institutional and retail investors only want to buy protection—they never want to be on the other side of the trade.

Sector options have been growing in number, though their uses remain somewhat limited. From options of the drug sector to high-tech to a recently launched set of options on mutual fund indices in certain areas (the Lipper/Salomon Growth Fund Index and the Lipper/Salomon Growth and Income Fund Index), the prime users of these options continue to be individual and institutional investors and mutual funds with sector bias.

The latest of this year's product introductions were the options based on the Dow Jones indices. Dow Jones resisted licensing its flagship Dow Jones Industrial Average, the 101-year-old index of 30 blue chip stocks, for years. But in October 1997, the Chicago Board of Trade and the Chicago Board Options Exchange started listing options and futures on the index as well as the Utilities and Transport Indices. And in January the American Stock Exchange began listing Diamonds, which are similar to its Spider product but use the Dow Jones Industrial Average, rather than the S&P 500, as the underlying. Although retail investors were expected to flock to the products, they havent caught on. Traders say the number of stocks in the index may be too small and that retail investors have been happy with the OEX options and don't seem likely to change.

The options market is becoming more volatile, and this has implications for all players, from traders and market-makers to investors. The bump-up in volatility can have a range of different effects, depending on where one stands in the process. And it also serves as an introduction to the arguments on the longer-term effects that option buying and writing have on the overall financial system.

On October 27, 1997, the Dow dropped 554 points. In an unearthly echo of 1987, investors darkly predicted the end of the bull market. It didn't end just then, though the speculator Victor Niederhoffer blew up his fund by selling a wodge of out-of-the-money put options on S&P 500 futures the day before, alerting all observers that options can hurt as well as help.

The growth in volatility of options has increased the price tag for buying protection. Since April 1997, the Chicago Board Options Exchange's measure of volatility has routinely hit an intraday high of 30 percent or more. Higher volatility means higher option premiums. Higher premiums indicate there is more money to be made in the game. "Should you want total protection,” explains Robert Arnott, director of First Quadrant, a tactical asset allocation and overlay manager in Pasadena, Calif., "meaning no loss of principal, that could easily cost you a significant percentage of the portfolio—10 percent to 15 percent—on an annualized basis when volatility is high. That doesn't make sense to most investors.”

"As the option market expands, the total amount of risk involved in stock market fluctuations rises by even more than the increase in the market's value.”
Andrew Smithers
Smithers and Co.

Another reason for rising option prices is scarcity. It is easy to find a bank or a broker to sell you an option. But the bank and the broker are having an ever-more-difficult time finding anyone to sell them an option. According to Steve Kim, an options analyst at Merrill Lynch, "In 1996, many portfolio managers were trying to improve returns by selling options. That meant they missed the enormous stock market rise. These people aren't going to make the same mistake twice.” If a bank or broker has to take it on the chin, by holding the other side of the option itself, that's going to cost option buyers a bit more.

It is also a simple fact that the world is a riskier place. Asia is imploding. The U.S. stock market, says Kim, has had three years of double-digit returns and must be reaching the end of a cycle. "Insurance has to be worth more and cost more today,” he says.

Which brings us to the worry warts and option bears. Call it fin de siècle, but a growing band of market pundits are coming to the conclusion that options writing, volatility and overvalued stock markets are a recipe for an impending disaster of the total financial meltdown variety.

In 1987, portfolio insurance didn't work, and in fact contributed to the market drop, because practitioners didn't completely understand the peculiarities of equity markets. Unlike fixed-income markets, equity markets do not trade continuously. Assuming practitioners used dynamic hedging (either via options or a simulated option), portfolio insurance theoretically should have been able to rebalance a portfolio synthetically to maintain the agreed floor on the portfolio's losses. "A replicating portfolio fails when there are gaps in prices,” explains Andrew Smithers, chairman of Smithers & Co., an economic consulting firm in London and a key option bear. "If prices drop from 40 to 20 with no stopping in between, portfolio insurance can't keep up.”

In 1987, the $80 billion of portfolio insurance in the United States failed, as users were unable to maintain their loss targets with the market falling so quickly and gapping intermittently. Why do options bears think that could happen again? Because, explains Smithers, there is a difference between insuring a specific risk and trying (and failing) to insure a systemic risk.

When a financial engineer wants to explain the conceptual basis for an option, the usual example is insurance. If you buy an option, the price of the option is equivalent to the premium paid for insurance. The problem with this analogy is that for the lay person, buying auto insurance means contracting with an insurance company for coverage for one car. "There is little risk that all cars will be stolen or crashed at once,” explains Smithers. "In fact, actuarially, you can predict with some degree of accuracy how many cars within a given group will be involved in a crash, for instance. The insurance company prices the insurance premium accordingly. But when you buy insurance against a stock market debacle through an index option, you are buying insurance against all stocks going down at once.” The car is a specific risk; market movements are systemic.

So what's the problem? If all car owners insure their cars, the risk to car owners is transferred to the insurance company, but because of the law of large numbers, the insurance company's aggregate risk is actually lower than that of all the car owners individually.

The same is not true for insuring systemic risk. In this case, says Smithers, the option buyer shifts the same or greater risk to the option seller. "What's more, as the option market expands, the total amount of risk involved in stock market fluctuations rises by even more than the increase in the market's value,” he says. "Because of the strong correlation of all stock prices within a market—and, indeed, between markets globally—it is possible that a huge percentage of value in the stock market could be wiped out suddenly, the equivalent of a nuclear disaster.”

In a paper Smithers coauthored with Cambridge mathematics don Steven Wright, the two took a crack at estimating the amount of insurance being provided by options markets worldwide. Their conclusion: $1.4 trillion to $2 trillion, with the caveat that given available data, these numbers only give an order of magnitude. They also suggest that the underwriters of this stock market insurance in the United States are on the hook for about 10 percent of the U.S. equity market, or some $280 billion to $400 billion, should the market decline by 30 percent. They say that will affect banks and broker/dealers that aren't capitalized well enough to withstand the shock.

Smithers doesn't contend that all this money is at risk, because dealers and banks hedge themselves against this exposure. "However, while you can hedge delta, it isn't possible to hedge the gamma and the vega. This is what makes the risks uninsurable.” The gamma risk in particular increases dramatically as markets drop, which is why Smithers contends that the financial system is at risk from the proliferation of options. "Options are underpriced because no one really believes that a catastrophe could occur, which is why I call this situation catastrophe myopia. If a significant market drop occurs, the taxpayer will be left to clean up the mess.”

The Year Single Stock Options Came of Age

Exchange-traded individual stock options grew like mad last year. No exaggeration. The Chicago Board Options Exchange posted a record 31 percent gain in single stock option volume and a staggering 36 percent gain in open interest at year end—12.4 million contracts. On the American Stock Exchange the story is the same—equity options volume rose by 67 percent, and options volume overall was up by 61 percent.

Retail investors used the exchanges to protect stock market gains and the more sophisticated engaged in return-enhancement strategies. Institutional players—both money managers and corporates—continued to access the single stock options markets to implement specialist strategies.

Two of the most popular strategies pursued by money managers, explains Tully Davia, director of institutional marketing at the CBOE, were the buy-write strategy for yield enhancement and collars to lock in the gains on a given stock. For corporates involved in the immense buyback activity of the last few years, single stock options that helped smooth that potentially volatile process were also popular. "If a company decides to buy in a fair portion of its stock, it can use options in one of two ways,” explains Davie. "Selling calls can allow the company to help fund the strategy up front. Or it can use options to execute the buyback at a specific price, and then buy the actual stock over a period of time.”

A new kind of retail investor has also entered the options fray—one that feels comfortable with leveraged long-term positions. According to Michael Bickford, senior vice president in charge of derivatives at the American Stock Exchange, investors flocked to the exchange's long-term equity anticipation security (LEAPS) options, taking positions and keeping them open. Paul Finnegan, director of retail marketing at the Chicago Board Options Exchange, also saw many retail investors purchasing LEAPS instead of the actual stock, because, he says, "Why buy a stock when you can lease it?”

Covered calls and covered combo strategies also found adherents last year. In a covered combo, an investor might want to buy 200 shares of a given stock, but finds it a bit too expensive. So he buys 100 shares and sells an out-of-the-money call and an out-of-the-money put. If the stock goes up, then he may have to sell the 100 he already owns. If it goes down, then the investor has to pay for the other 100 shares at a better price. "We suggest that people have the money in the bank to buy the next 100 when the put on the strategy, otherwise it could prove risky,” says Finnegan.

The CBOE lists more than 1,100 single stock options, but the top 10 of 1997 reflect the stock market's most liquid stocks—and those that investors are most wary of (in descending order): IBM, Cisco Systems, MCI, Coca-Cola, Texas Instruments, Hewlett-Packard, GE, Oracle, Telebras ADR and Merck. A hit parade, indeed.


Few in the options markets concur with this disaster scenario, though none considers the business a cakewalk either. "The only way to run a successful desk,” explains NatWest's Goldsmith, "is to understand that you need to run as much of a matched book as possible. I think there were desks that were caught short in October 1997 when the market dropped so quickly. You do not want to be long gamma in a falling market, and the only way to guard against that is to access liquidity from wherever you can.”

Being short volatility in equity options is a dangerous game. "I think banks are too smart to get caught in the scenario that the doom and gloom merchants are selling,” says Merrill's Kim. "For one thing, the estimates of exposure only look at one side of the transaction. All banks and brokers hedge, run match books and employ risk managers to oversee just these kinds of risks. Yes, people make mistakes, but they don't do it for long. People have learned from their mistakes.” Kim points out that while it isn't possible to hedge gamma, it is possible in some instances to hedge vega by selling volatility swaps.

In the U.S. market in particular, the immense liquidity, the variety of possible hedging strategies and internal risk management controls suggest to most on options desks that catastrophe isn't around the corner. The only way to understand fully the risks run by options trading institutions is to look at the situation from the inside out, by looking trade for trade, pair for pair, something that Smithers and Wright didn't attempt to do.

So look for continued growth in options trading—and protective strategies of all varieties—in the future. Investors haven't found it particularly wanting lately, and traders remain confident in their abilities to stay ahead of the gamma risks. Good traders can be long volatility in most markets. "When trouble hits,” says NatWest's Goldsmith, "I don't want to be betting the under [as in football], I'd rather be betting the over.”