Hedge funds continue to be one of the most dynamic users of both exchange-traded and OTC options, especially in the US, but certain managers could still not be using the opportunity that these instruments can provide them.
Equity-based investment strategies manage hedge funds, which account for a large portion of the equity options market. Several funds focus on the liquid US equity markets and use single stock options, ETF and index options to hedge risk.
Types of Option-Based Strategy
Covered put or call options have always been a feature for the long/short equity manager, especially in markets where there is an extensive availability of single-name contracts.
For e.g., in Asia, the choice of single name options is extremely restricted, managers are still dependent on OTC contracts or basic volatility strategies.
The equity hedge fund could use index based puts and calls to economically hedge upside or downside exposure. Managers have been able to concurrently profit from both long and short positions using options. But, it is hard to accomplish constant returns on the short side during an upward-trending market as call selling is not a ‘set and forget’ strategy.
There are extremely sophisticated defensive strategies that regularly make use of options such as hedging tail risk. Hedge fund managers are very careful, as a result of the global financial meltdown in 2007-08. They need to assure investors that the fund is ready for the next black, grey or swan event.
It has also been realized that the value of put options (not only equity puts) collapsed during occurrences of high volatility (e.g. the credit crisis and the flash crash), resulting in more fund managers exploring options as a substitute to defensive cash and Treasury bond holdings.
Covered call selling and yield improvement
The transaction of covered calls by hedge funds is preferred during phases when fund managers are comparatively neutral on the market. This creates premium income and reduces the probable downside exposure of a long underlying position.
One of the major risks with a yield-based strategy is that the holder of the option chooses to exercise it to secure the dividend. Though the best profit and breakeven are understood from a risk management outlook, the possibility of the option being exercised is also extremely quantifiable, with a delta of .95 or above being an excellent benchmark.
There is also a possibility of an early assignment risk for American style options as the long holder of call options could exercise at any time prior to expiration, but most likely when the dividend is more than the excess premium over intrinsic value.
Volatility-based strategies make the best use of options, with implicit volatility viewed as one of the most vital constituents of options valuation.
Several hedge funds utilize options to speculate on the direction of implied volatility. For e.g., using CBOE® VIX® options or futures. Since implied volatility itself trades within a dimension that could be described through technical analysis, a fund could focus on the probable buying and selling points specified through traditional price bands.
Options could be utilized by the activist fund to take advantage of various arbitrage conditions. Volatility arbitrage has progressed from a hedging method to a strategy in its own right. There are a large number of hedge funds trading volatility as a pure asset class.
Essentially, hedge fund options desks could arbitrage options prices on their own, instead of using them to arbitrage other asset classes, using various options recorded on a similar asset to take advantage of relative mispricing.
The dispersion trade has become very prominent with hedge funds that would like to bet on an end to the high-level of correlation between the huge stocks that create index constituents. A fund manager would normally sell options on the index and buy options on the individual stocks comprising the index.
If maximum dispersion happens, the options on the individual stocks generate income, while the short index option loses only a modest quantity of money. The dispersion trade is efficiently going short on correlation and going long on volatility.
The investment manager requires having a proper insight on when such a situation is likely to occur and investors look to focus on data from individual stocks instead of taking a vanilla ‘risk on, risk off’ tactic to equities.
Tail risk funds
It is a fund developed to deliver liquidity in the event of specific risks happening (for instance stock markets crashing by over 20%). It has become a popular portfolio constituent for investors requiring to meet liabilities in the event of market liquidity declining.
Options are a vital asset class used for algorithmic funds because of the increased use of electronic trading for options transactions. One of the important selling points for hedge funds has been the liquidity and operational effectiveness related to exchange-traded options.
Increasingly, hedge funds are implementing weekly options to control positions, allowing successful positions to be developed quickly. They could also deliver competitively priced downside safeguard.
As the options sector continues to develop, further prospects would occur for hedge fund managers.
This would stem not only from the enlargement of the product group available but also from the improved operational effectiveness and transparency delivered by exchange-traded and cleared products. Regulatory demands for a very dynamic marketplace would also play a significant role.