Many funds focus on the liquid US equity markets and use single stock options, ETF and index options to hedge risk. This article takes a brief tour of some of the ways in which options are being employed in hedge fund portfolios, as well as looking at some of the broader themes affecting their use. Future articles will look in more detail at some of the most widely used options strategies. In Asia, where the choice of single name options remains very limited, managers are still reliant on OTC contracts or simple volatility strategies.
The equity hedge fund can use index-based puts and calls to cheaply hedge upside or downside exposure. Managers have been able to simultaneously profit from both long and short positions using options.
There are more sophisticated defensive strategies that make regular use of options, like hedging tail risk. Hedge fund managers are highly cautious, as a result of bad experiences in They need to reassure investors that the fund is braced for the next black — or grey — swan event.
It has also been observed that the value of put options — and not just equity puts — exploded during episodes of high volatility e. Covered call selling and yield enhancement The sale of covered calls by hedge funds is favoured during periods when fund managers are relatively neutral on the market. This generates premium income, and mitigates the potential downside exposure of a long underlying position. One of the biggest risks with a yield-based strategy is that the holder of the option decides to exercise it to capture the dividend.
While the maximum profit and break even are fairly clear from a risk management perspective, the likelihood of the option being exercised is also highly quantifiable, with a delta of. There also exists an early assignment risk for American-style options as the long holder of call options may exercise at any time prior to expiration, but most likely when the dividend is greater than the excess premium over intrinsic value. Volatility Volatility-based strategies arguably make the most use of options, with implied volatility regarded as one of the most important components of options valuation.
Because implied volatility itself trades within a range that can be well defined via technical analysis, a fund can focus on the potential buying and selling points indicated via established price bands. Using straddles put and call options bought or sold at the same strike price with the same expiry and strangles out of the money put and call options , managers can also take advantage of the volatility strike map curve — i. Volatility trading is also popular with algorithmic hedge funds, which can focus on trading it in favourable ranges while retaining a hedging capability.
The fund uses the premium cash from its sale of calls to buy puts based on the index it is tracking, thereby both reducing the total cost of the strategy and potentially dramatically reducing the risk. Arbitrage Options can be used by the activist fund to exploit a number of different arbitrage situations. Volatility arbitrage has evolved from a hedging technique to a strategy in its own right. There are a sizeable number of hedge funds trading volatility as a pure asset class, with systematic volatility strategies seeking to exploit the difference between implied and realised volatility.
Funds can profit from this by using options while hedging out other risks, such as interest rates. Fundamentally, hedge fund options desks can arbitrage options prices themselves, rather than simply using them to arbitrage other asset classes, using multiple options listed on the same asset to take advantage of relative mispricing.
Dispersion trades The dispersion trade has become increasingly popular with hedge funds that want to bet on an end to the high level of correlation between the large stocks that constitute index components. A fund manager would typically sell options on the index and buy options on the individual stocks composing the index. If maximum dispersion occurs, the options on the individual stocks make money, while the short index option loses only a small amount of money.
The dispersion trade is effectively going short on correlation and going long on volatility. Tail risk funds The tail risk fund — a fund designed to provide liquidity in the event of certain risks occurring e. This is really an insurance policy, with the investor exchanging an underperforming strategy for the expectation of liquidity.
Tail risk funds often take contrarian macro positions by using long-term put options. The debate over whether it is really possible for a fund to anticipate tail risks — by definition hard to predict — must be offset against the expectations of the investor. The investor is looking for a bear fund to minimise portfolio damage. The cause of that downturn may be unpredictable, but the reaction of the market can be predictable.
The real question is the size of the market decline. With the advent of tail-protected ETFs for investors and given recent trading patterns, it is clear that products that can provide this level of hedging will continue to be popular with investors. The big picture Options are the third most widely used asset class for algorithmic funds after equities and foreign exchange. This is thanks to the increased use of electronic trading for options transactions, trades that were previously reliant on manual options writing and voice broking.
One of the key selling points for hedge funds has been the liquidity and operational efficiencies associated with exchange-traded options. In particular, advances in algorithmic trading have permitted fund managers to access superior pricing across multiple exchanges via smart order processes. Outside North America, locally traded equity options have not been enjoying the high growth experienced by US equity options.
In Asia, single stock options are hampered by lack of opportunity and demand, while in Europe structural features such as country and currency fragmentation, and a preponderance of smaller company issues are retarding growth see Fig.
Increasingly, hedge funds are embracing weekly options to more sensitively control positions, enabling successful positions to be harvested more quickly. They can also deliver competitively priced downside protection. Time decay is attractive to sellers, while buyers appreciate the gamma play — the ability to harness an upward move in the options delta, in response to a proportionally smaller rise in the price of the underlying.
As the options industry continues to develop, further opportunities will likely emerge for hedge fund managers. This will stem not only from the broadening of the product set available, but also from the enhanced operational efficiencies and transparency offered by exchange-traded and cleared products.
Regulatory demands for a more robust marketplace will play no small part in this too. The Options Industry Council OIC was formed in to educate investors and their financial advisors about the benefits and risks of exchange-traded equity options.
Options industry professionals have created the content in the software, brochures and website. Appropriate compliance and legal staff ensure that all OIC-produced information includes a balance of the benefits and risks of options. The views expressed are solely those of the author of the article, and do not necessarily reflect the views of OIC. Skip to main content.
The Options Landscape for Hedge Funds Hedge funds remain one of the most active users of both exchange-traded and OTC options, particularly in the US, but some managers may still be missing the opportunity that these instruments can offer them.More...