Institutions Wade Through Options

Terry Flanagan

Regulators may have vilified derivatives in recent years, but such instruments may be a savior to institutions in times of high volatility.

Though the 2008 financial crisis largely places blame on mortgage derivatives, and over-the-counter (OTC) instruments, some believe in derivatives that can prevent another financial catastrophe.

Such is the case with options, most of which are exchange traded derivative contracts. And like all instruments, options have their place among end users of the market. For some end users, notably, institutions, open arm attitudes towards options have been lukewarm, at best.

“The move of institutions adapting options is changing but moving slower than we’d like,” said Jay Easterling, managing partner of Gargoyle Group, a practitioner firm of options implementation for buy-side institutions, such as pensions, who wish to hedge their bets.

The New Jersey based firm largely conducts research for education use of tepid options users to turn up the volume on options usage in portfolio construction.

“A lot of what we do is educational. When you’re in a mature market, you’re making a case for ‘why us.’ In a less mature market (i.e. institutions using options), you’re making a case for why what we do makes sense at all—that makes the business cycle much slower.” Easterling told Markets Media.

Options, with their sometimes perceived “scary” derivative characteristics have often been coined very expensive for some rather vanilla, straightforward institutional portfolios. Such a frequently-heard concern is a misperception, for Easterling.

“The ‘expensiveness’ of options is based on a limited knowledge of the flexibility of options approaches,” he said. “Overtime, they can enhance smooth equity performance.

They’re a leap of faith in all down markets—such as commodities, when for example, the cost of buying gold protection via options is far lower cost.”

This year has widely experienced such down markets, especially given the equity volatility seen in the third quarter of 2011.

“Tail risk,” or the unlikely risks that occur most in unpredictable, volatile times, has been on the forefront of minds of the buy-side—an environment that has opened doors for options, according to some market participants.

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