With volatility resurfacing and fears about the stability of the global economy persisting, institutional and retail traders alike have been turning to alternative investments as ways to cope with the anxiety and uncertainty in the markets.
While the popularity of alternative asset classes, ranging from equity options to currency and gold futures, has been growing for several years, participation in alternatives among asset managers and retail investors has skyrocketed this year as traders have sought to cushion their portfolios against the zigzagging stock market or, conversely, to make bets on the volatility.
Wild intraday swings in the U.S. stock market have driven institutional traders and retail investors to hedge their positions with listed derivatives to protect themselves against sudden market plunges. As anxiety rose this summer, options trading volumes reached a record high in August.
According to data from the Options Clearing Corp., which clears trades for all nine U.S. options exchanges, more than 554 million contracts were bought and sold in August 2011, representing a 94 percent increase from August 2010's 283 million contracts.
"In September 2008, a month before Lehman went bankrupt, we had huge volatility, but we didn't see this kind of volume," recalls Jim Binder, a spokesman for the OCC who attributes the heavy options volume to the influx of both institutions and retail traders. When institutions saw the indices drop nearly 40 percent during the financial crisis, they discovered the risk management potential of options and entered the market head first, he explains.
The uncertainty generated by the political gridlock in Washington over the U.S. debt ceiling, Standard & Poor's downgrade of U.S. Treasuries' triple-A credit rating and concern about the ongoing European debt crisis also contributed to the heavy move to alternatives, which is reflected in the price of gold futures (gold established a new high of $1,923 a troy ounce during the first week of September). According to John Netto, president and founder of M3 Capital in New York, the macroeconomic situation is the No. 1 reason alternative investments have become more popular.
Traders are moving into alternative investments because of the increased volatility in the equity markets, says Netto, an index options trader who focuses on global currencies and precious metals. "People are concerned about sovereign debt and the debasement of the currencies," he says. "There's more participation in this space by necessity."
Plunging stock prices pushed up the CBOE's Market Volatility Index (VIX), known as the "fear gauge," past 39 in early September; while this still was far lower than the 80 seen during the 2008 financial crisis, "It had doubled over the past three months," points out Netto. As a global macro trader, Netto says he looks at the index options where there are opportunities. "I trade fixed income, metals, energy - I like to compare volatility across all those asset classes," he reports.
In Search of Higher Returns
But volatility is only part of the story. Investment managers are turning to equity options, index options and even options on ETFs not only to hedge their portfolios, but also to boost returns in a low-return environment. "People are realizing that 'buy and hold' doesn't cut it anymore," comments Stephen Davenport, director of risk management, investment management, at Wilmington Trust in Atlanta.
"And so we need to be more aware of risk tolerance and try to be more active in mitigating risks when clients require it, and listed options are one of the best ways to do it."