Guest Author: Ken Kwalik, Managing Partner, Carrick Lane

Key Points:

• The use of options in professionally managed products has remained strong for decades, even with substantial market turmoil at times.
• Investors have more choices than ever for a strategic, scalable allocation that matches their investment objectives.
• Now may be an attractive time to combine with other risk premia such as equity or fixed income to create a simple, efficient investment that fits with an investor’s views and portfolio allocation.

Options-based Strategies: Consistent Growth Gives Rise to a New Asset Class

Over the past 20+ years, options usage has evolved well beyond point-in-time transactional products, and volumes continue to increase nearly every year. Today, the options market continues to grow as more and more professionally managed products offer solutions or enhancements to several kinds of investment objectives.

This evolution is important because, after a decade of relative calm, global markets have since encountered multiple severe, far-reaching selloffs affecting all asset classes, including derivatives, over the past few years.

The global financial crisis of 2008-2009 saw the natural attrition of the hedge fund community affecting many natural options sellers on the client side. Simultaneously, several global banks with significant market-making businesses on the liquidity-provider side either downsized their derivatives footprint or became insolvent. Negative disruptions occurred once more in 2018 and 2020.

After each downturn, the industry recovered quickly and arguably came back stronger than before—with both legacy franchises and new players from all sides of the options world continuing to provide access to markets and products in a consistently functional way for investors of all types and sizes.

Current Structural State: Market Developments Help Evolve Strategies and Improve Management Flexibility

Cboe® continues to release new, innovative products including several “pure volatility” vehicles across the Cboe VIX® Index franchise and important upgrades to existing, more traditional index option products such as the Cboe-exclusive S&P 500 Index options (SPX®) or Minis (XSP), MSCI index options and several others.

Having more strikes, terms and even daily hours to trade, without sacrificing the institutional-quality liquidity, price discovery or quote quality expected of these products, enables managers to navigate risk in a more efficient manner, and to scale total available size, customization features and more.

Two longstanding strategies familiar to investors can benefit from the expansion and growth of products in the options market:

• Collateralized put writing — an investor seeks to generate yield and/or enter an equity position, usually via selling a downside index put option and collecting premium.
• Covered call writing — an investor seeks to exit a concentrated equity position and/or generate yield, usually via selling an upside single stock or index call option and collecting premium.

Many additional strategies, such as hedged-equity, equity replacement, volatility arbitrage and others, can benefit from these developments and continue to gain significant traction.

The overall growth of these strategies over the same timespan has been strong, and with continued volatility in the core equity and fixed income markets, it is reasonable to assume growth may persist. From a client perspective, there are several important reasons for this:

1.) Simple Alignment of Investment Objectives with Core Allocation: Even just these basic strategies can solve a variety of objectives for investors, either tactically (stock exit around specific levels/events) or strategically (generating income over time via put sales), and often at the same time, implemented in different parts of a multi-asset underlying portfolio.

2.) Accessibility: Many of these strategies are available in straightforward implementations, such as separately managed accounts or fund structures, which can offer better liquidity and transparency than other liquid-alternative hedge fund structures.

3.) Efficiency: These strategies can be run as overlays, providing investors with significant potential capital efficiency (including over existing holdings, potentially in other accounts using margin), as well as potential tax-efficiency via 60/40 U.S. tax treatment of cash-settled major-market indices.

Manager offerings featuring options have increased to meet this demand, measured by not only overall assets under management but also by consistent liquidity (in listed fund vehicles) or official, GIPS-compliant/audited track records (in separately managed accounts). This is in addition to many strategies passing thorough institutional-quality due diligence, having proper ongoing research coverage and a robust presence in global investment databases with benchmarks. Product education such as Cboe’s Insights blog series and live events are an essential component of good client experience and key to responsible long-term growth.

Current Market State: The Volatility Risk Premium as a Different Return Driver

These continual structural improvements are certainly helpful for options strategies. However, it is also critical to understand the key drivers of performance, especially given the context of the past few years and recent heightened volatility.

Fundamentally, options tend to exhibit a risk premium—or demand a cost to own above their expected value. Like an equity risk premium, or a fixed-income term structure premium, this is often referred to as the volatility risk premium (VRP). Simply stated, VRP suggests that over time options tend to cost more than the underlying security would imply. Much research has been done on this topic, including a blog in this series from Seth Hickle and James Humphries of Innovative Portfolios.