The appetite for options trading among institutions is increasing as they seek to generate income, capture alpha from volatility, and hedge their equity portfolios. However, care must be exercised in integrating options trading into the portfolio mix.

“In order to be successful in developing and offering competitive options strategies, institutional investors need to efficiently combine options trading and risk management together with the more traditional portfolio management functions inherent in underlying fundamental or quantitative portfolios,” said John Burrello, senior trader at Invesco. “If those words and music cannot be put together, then an institutional investor will not be able to adopt a competitive options strategy.”

Given the uncertain market conditions, institutional investors are turning to options to hedge their losses, mitigate risk and increase their income stream, said Rob Brogan, vice president, equity derivatives at FlexTrade.

“Because of the recent market crisis — the ‘flash crash’ to name one — institutional investor tolerance for risk has become quite low, and by using options as a hedge, the institutions have allowed themselves to continue with their current strategies and asset allocations while achieving the low risk they crave,” Brogan said.

For investment managers that are just recently expanding into product offerings that include options, there will be hurdles with charters, internal committee approvals, and developing expertise and technology. Those hurdles can be cleared, and the first step is educational outreach on the part of the industry.

“With institutional investing with options, education is part of the ongoing relationship with clients,” said Burrello. “We do believe both clients and investment managers are increasing the effectiveness of their education efforts, which is driven by the recognition of the benefits that options can have in portfolios.”

In an April 29 blog posting, Dan Mikulskis, co-head of asset & liability modeling at Redington, a UK-based provider of investment strategies to pension funds and insurance companies, enumerated various ways that options can be utilized by institutional investors:

As directed trades at an institution level, perhaps a macro-level hedge against falls in equity levels or interest rates.

At an individual mandate level, in a strategy where options are inherent to the nature of the strategy; for example a strategy that attempts to monetize the premium between implied and realized volatility, a call-overwriting strategy or a tail hedge protection-buying strategy.

At an individual mandate level, to represent macro views. In a recent review of diversified growth fund managers (who typically manage money on behalf of retail, defined contribution and smaller defined benefit funds) 13 out of 15 managers employed options in this way, according to Mikulskis.

As a risk management tool, the ability to use options as an risk overlay on much larger investment programs provides an ability to gain long volatility exposure.

Options trading has been much more self-directed by the retail client and their financial advisors (the ultimate client of institutional investors) than traditional equity investing where the benefits of institutionally managed mutual funds are well understood. Today, around 30% of all trading at major online brokers is done in options.

“Now we’re seeing that retail and institutional investors are seeking the benefits of professionally managed options portfolios with more efficient access and liquidity than has traditionally been available in the hedge fund space,” Burrello said. “This has spurred a large push in the industry over the past couple of years to educate institutional investors through seminars, conferences, and teach-ins with the same goal that retail platforms have had for the past decade – to empower the usage of professionally managed options portfolios as an attractive liquid alternative to traditional asset allocation strategies.”