There’s more than one way to grab alpha in today’s equity markets than just buying or selling stocks.

And that’s using options.

According to Grant Johnsey, Head of Institutional Sales at Northern Trust’s Brokerage division, who recently spoke with Traders Magazine, options can be effectively used in a buy-side trader’s portfolio easily and boost his alpha capture. Grant explained that when working with institutional clients, he’d seen a traditional reluctance to incorporate option strategies into their investment strategies, fueled in part by the perceived additional risk they carry. Part of that reticence comes from the traditional divisions of labor inside investment firms – options based strategies do not fall neatly into the traditional buckets of equity, fixed income, or alternatives.

He argued this permits pension funds and other institutional investors to miss out on opportunities that options can be an effective means of enhancing alpha and reducing risk. But now as alpha generation and preservation becomes increasingly incremental and difficult, Grant now is seeing a trend of adding option-based strategies to the investment portfolio of many institutional clients.

“We have seen a marked increase in the number of institutional investors that are utilizing or considering option based strategies,” Grant began. “It’s a shift from what we’ve seen in the past.”

Historically, Grant said that options had been primarily used by either fund managers or hedge funds. These users would typically be using them to either express a view on a particular stock or segment of the market, or perhaps use as a hedging vehicle or enhance a previously established view on the market. Not so anymore.

“What’s different in this shift is that the demand or inquiry into the use of options is coming from the actual institutional asset owners,” Grant explained. “So, it’s coming from the pension fund or the not-for-profit/endowment. And the inquiry is not as much about expressing a view, not even necessarily how to hedge themselves, but more so a trend is on actual income generation.”

So, options are being used – but just what types of strategies? One leg or multi-legged?

As Grant sees it, both strategies are being used by different buy-siders.

“It depends on the fund manager hired,” he explained. “Primarily we are seeing simple strategies, namely covered calls or buy writes.  Some managers have slightly different takes on how to implement.    We also see growing interest in multi-leg strategies, namely selling volatility as well as tail risk hedging.”

Not all options are created equal though -as some managers have certain investment time horizons while others have different ones. So, what do they prefer – monthlies, weeklies or even dailies?

Grant said institutional users are opting to get their feet wet with the monthly expiration options.

“We see thirty-day maturities used quite a bit. But there are others that go further out the expiration curve as well,” Grant said. “I even know a couple of investors who’d go way out the curve even further.”

Further would mean using six month expirys, but Grant said the bulk of users – both new and existing – prefer to stay in the one month expiration. But there are those who also choose to go shorter duration, such as weeklies. No one he knows uses dailies – yet.

So, are investors getting comfortable with using riskier options than plain single stocks? Or is purely an alpha grab?

“I don’t think it’s an alpha question here but more so a yield one,” Grant said. “If I have certain return expectations and I’m looking at a ten-year government bond that is whatever it is today…two and a quarter percent, but my actuarial assumptions are closer to six percent a year, how do I bridge that gap? Especially if I think about matching up liabilities to my investment spectrum and that’s where you’re seeing some of this come into play – as a way to maximize yield. So, it’s not necessarily an alpha play in many cases.  For this reason, covered call strategies are receiving the most interest here.”

He added that there’s even some contemplation from certain clients who are looking at high- yield portfolios. As high yield bond rates have stagnated recently and with the Federal Reserve contemplating raising interest rates, these non-traditional users of options have engaged in move into covered calls.

Why?

“Because the yields right now on covered calls are markedly higher than anything you can get in investment grade and high yields might be at the end of their bull run,” Grant said. “We’re seeing yields on covered call strategies that are greater than what you can get in yields in high yield bonds.”

And let’s not forget that today’s investors and traders are increasingly savvy about the various asset classes and the risk/return profile they offer. Grant said that investors are indeed smarter and getting more educated on new strategies, such as listed options, versus moving into OTC stocks.

“We also see where folks are doing more stock specific covered call writing as they’re typically using some discretion as the investment manager to select stock they also have a positive view on,” he added. “We’re seeing covered call strategies in today’s market using large cap US equities generate a yield in excess of 8 percent annualized.”

Is the use of options a short-term phenomenon or more of a longer-term trend? Grant thinks the usage of options has momentum and legs.

“I think that we’re still at the margin on options usage,” he said. “It does require some education at the investor level and particularly with the investment committee because most of these funds are run by committees and consultants. There needs to be some getting comfortable with derivative based strategies since they’re not common and that’s not just by the way at the institutional investor level but that’s also at the investment consultant level. I have yet to see any investment consultants recommend or push these options based strategies. We have not seen any investment consultants that have embraced this in fact as strategy at all.”

But for Grant hope springs eternal. As alpha capture needs continue and investing in stocks or bonds can have limited upside – stocks being too pricey and bonds subject to rising interest rates – options are a viable alternative.

“Listed options right now are en vogue and something we do here at Northern very well. We’re seeing a lot of listed options trading,” Grant said.