Observer: Investors could be taking the wrong option

The Australian Stock Exchange (ASX) recently announced that volume in company exchange traded option trading had reached record highs in August 2004, with 65 per cent of this transaction volume coming from retail investors.

This has raised questions as to whether some investors are getting out of their depth in these activities in the derivatives market. A rash of advertised seminars and software promising riches from trading options is also raising concerns.

There is no doubt some retail investors have become more sophisticated and they and/or their brokers or advisers are approaching options in a sensible way.

However, the focus of the growing option activity in certain strategies that have benefited from the investment environment of the last few years suggests some investors could be in for adverse surprises down the track.

Interestingly, relatively few investors seem to be using options primarily to buy downside protection (that is, through the purchase of put options or through ‘collars’ where one writes or sells out of the money call options and uses the premiums earned to buy put options).

Volume and open interest in put options is still far below that of call options.

Historically, calls were generally sold or written by professionals and bought by active traders leveraging a view on a particular stock or index. While the latter group is still present, the most pronounced development has been much higher levels of call writing by retail investors presumably against shares they hold (the so-called ‘buy and write strategy’).

Perhaps this activity has been partly fuelled by the ASX itself which recently introduced a ‘buy/write’ index, whose history showed that a portfolio of bought and sold calls had actually outperformed the All Ordinaries Index with lower volatility since December 1987.

There is no doubt that writing out of the money call options against a portfolio of shares may assist in smoothing the return from the portfolio over time and for many investors this is a desirable outcome. It does this through the combination of providing premium income along the way, but also cutting off some of the upside when a stock rallies sharply (because the stock can be ‘called’ away or exercised by the call buyer once it trades ‘in the money’).

However, one could argue that recent years have been an ideal environment for writing call options against Australian leading stocks.

The market (and many individual stocks) has been in flat to modest up-trends. The implied volatility priced into stock options has been high, meaning premiums earned have been generous (although these have been falling in the last year or so).

Sharp spikes upwards in leading share prices that result in investors being forced to sell stock and miss out on upside have been relatively few and far between. There have also been relatively few true disasters in the leading stocks where most options are written.

Investors have felt they are gaining the best of all possible worlds — ownership in a portfolio of gradually growing and franked income-paying shares, with the sold call options providing some extra income that provides a degree of protection if shares fall.

Of course, in a major stockmarket sell-off, sold call options would not do much to protect individual shares or a portfolio. Some investors suggest if you really are concerned enough to want to protect the shares, you should sell some or all of them.

Further, selling options is not the only way to help produce a smoother or protected investment portfolio.

A better approach may be simply building a more diversified and value orientated portfolio incorporating non-correlated assets. The equity component could then be focused on a portfolio of well-selected stocks or quality equity funds without the need to be concerned about explicitly protecting or adding income to these.

The problem is the option market is not a free lunch and the retail investor in such markets is often paying higher prices just for the leftovers.

As derivatives on the underlying shares, the options market creates additional infrastructure and employment that ultimately must be paid for by users of options. As the least sophisticated investors in the market, retail investors usually end up paying more than their share of this extra cost by virtue of higher spreads and a lack of awareness of what the ‘correct’ prices should be.

Option markets clearly provide opportunities, but mainly to full-time professionals in the area such as market makers and some hedge funds which can take advantage of small price inefficiencies.

Option pricing is a complex topic even for professionals. Even the standard models such as Black and Scholes that are now easy to access have some problems in practice. After all, Black and Scholes assume that returns from a company stock are normally distributed. In the real world, the return distributions often have ‘fat tails’, suggesting that extreme outcomes (particularly bad ones) are underestimated by the model.

The case against selling options (either naked or against stocks) is probably best put by Nassim Nicolas Taleb in his recent book Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life.

His view is that many options are not priced appropriately for the probability of extreme events, and that intelligently buying options can be a better strategy — one that he implements in his “crisis hunting” hedge fund.

Under this approach, you come to work expecting to lose a little money virtually every day until a big gain from a fat tail event comes along. It is clearly not a strategy most retail investors would be particularly comfortable with.

Using put options as a way to buy protection of a portfolio (particularly an all equity portfolio) may well be a sensible approach for some investors concerned about near term risks. It can be particularly useful in the context of an Australian tax system that advantages longer term capital gains and franked dividends.

However, investors need to remember that this is like an insurance premium, that they often do not get the best price and like insurance, they should forget the premium the day they pay it.

On the other hand, simply selling calls against a portfolio will not provide much protection when it is most needed, that is, in a major market sell-off.

The growth in exchange traded options on shares is just one small part of the dramatic explosion in derivatives in recent decades.

While there have clearly been some positive developments from this growth, it would not be a surprise if there were problems in some parts of the derivatives industry in coming years. Fortunately, this is less likely to be in the more regulated exchange traded area and more likely to be in the still largely unregulated ‘over the counter’ option markets.

Still, given informational and implementation disadvantages facing retail investors, I suspect many would be better off leaving options to the professionals.

As the poker saying goes, “If you’ve been in the game more than five minutes and you don’t know who the patsy is, you’re the patsy!”

Dominic McCormick is chief investment officer for Select Asset Management .