03.14.2014
By Terry Flanagan

Equity Traders Exercise Options

Equity traders who wish to use options as a hedge but lack mastery of derivatives have had to rely on broker-supplied expertise, with often disappointing results.

Suppose, for instance, a trader has a view on Chipotle—its earnings, the probability of its price going up or down and by how much—and wishes to add an options overlay to hedge risk, create leverage or both.

“Today, I call my high-touch broker, and talk to someone in the derivatives sales area, and while I’m talking about my view of what’s going to happen with Chipotle and my risk appetite, the sales trader is talking about volatility or other extraneous topics. So we are talking at cross-purposes,” said Gideon Agar, CEO of Tradelegs, a provider of options optimization strategies.

There’s a better alternative, according to Agar, and that’s to harness options optimization technology and make it amiable to traders in order to allow them to use options to generate alpha.

“The market we’re addressing is the professional investor who has an equity-centric view of the world,” Agar said. “How does he increase alpha while at the same time hedge risk more precisely by expressing his views and risk profile through the use of options? It’s about managing the tradeoff between risk and reward, and simultaneously maximizing alpha while precisely controlling risk. Options are a great tool for doing that, but it’s particularly hard to do.”

What’s the best strategy? “We believe it’s the one that maximizes your returns if your equity prediction is right, while at the same time managing your downside risk in case your prediction is wrong,” Agar said.

The Tradelegs Optimizer evaluates every possible way of putting on a multi-leg position, using the equity and its entire options chain. An equity prediction editor lets the trader express very simple views (e.g. “I think the stock will drop 5% to 15%”), or enter a full decision tree with conditional events and outcome.

“It looks at everything that could affect your outcome,” said Agar. That’s why it’s a professional grade solution that hedge funds and other large institutional investors can rely on.”

Chicago Board Options Exchange is planning to invest in Tradelegs, in part to promote wider use of its core products such as VIX and SPX.

“Our planned investment in Tradelegs is a natural fit for CBOE. The technology’s application supports our strategic objective to further expand the institutional use and appeal of options trading, including with our proprietary index products,” CBOE CEO Edward Tilly said in a statement. “Tradelegs’ advanced analytics and intuitive software make it a valuable trading resource for institutions that want an uncomplicated way to formulate options-based strategies that could enhance their equity positions.”

Added Agar, “We and CBOE believe there’s a latent demand for options usage by people with a fundamental equity-centric view of the world but would like to be able to add options to their toolkit. For CBOE, this allows them to release that latent demand for options in general, as well as for its proprietary products. CBOE is helping us financially and providing additional insight into how options behave, and are helping us with market access, through introductions and their endorsements.”

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