04.04.2012
By Terry Flanagan

Pensions Warm Up to Options — Slowly

Are options risky, or do they reduce risk?

That is a question investment decision-makers at pension plans increasingly have been mulling. Known historically for comparatively staid, plain-vanilla investing, more pensions have been deploying options as part of a broader investment strategy.

Investors’ perception of options “is definitely changing,” said Phil Gocke, managing director at the Options Industry Council. “There has been a long-held fear of derivatives use, from the perspective that they increase leverage. Today, people are starting to realize options are not weapons of mass destruction, but rather, they can be a highly effective risk-management and yield-enhancement tool.”

Options practitioners, of course, want pension plans and other institutional investors to use options. New users benefit options traders by making markets more liquid, exchanges and broker-dealers stand to gain from the additional order flow, and a broader universe of market participants means more customers for technology providers.

But beyond the self interests of market participants, there is objective evidence that options can allow institutional investors to avert losses. This manifested itself most recently in the 2008-2009 financial crisis, when an effectively deployed options strategy would have protected an equity investor from much of the market’s pain.

 

Options market participants cite the institutional space as an important, under-penetrated area. Many of the largest pension plans are at least familiar with options and many trade the securities; it’s hit or miss with mid-sized and smaller institutions, many of whom either are barred from trading options via their investment charter, or if they are permitted to trade options they may simply choose not to.

The volume of institutional order flow is what makes pensions and other investment organizations so attractive to options practitioners. Indeed, even a limited options strategy adopted by a mid-sized, $1 billion pension plan can generate more volume than would dozens of active retail-level options traders.

There is ongoing progress in converting mid-sized institutions to options strategies, but the conversion rate is akin to a trickle rather than a torrent, according to market observers. The San Antonio Fire & Police Pension fund recently adopted a covered-call option strategy, one market source said. Executives at the pension fund did not respond to requests for comment.

 

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