Running With the Pack - Part 2

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...Continued from Part One

THE SOLUTIONS
How can this problem be fixed? First, financial planners have to overcome the perception that options are extremely complex instruments that should only be handled by specialists. The truth is that the vast majority of option trades are quite simple. For those of you who havenít cracked a textbook since your series 7 or 63 exams, hereís a brief refresher course on options. Options come in two distinct flavors, calls and puts. Calls give you the right to buy a security at a specified price by a specified time. Puts give you the right to sell a security at a specified price by a specified time. In a nutshell, calls make money when the market goes up and puts make money when the markets go down. While the definitions of calls and puts are relatively straightforward, quite a few financial planners have difficulty explaining these instruments to their clients.

Part of the problem is that most investors are used to owning tangible assets like stocks, bonds and mutual funds. Options, however, are far more ethereal. Instead of owning a piece of a company or a claim on their debt, you own the right to make a future trade in their stock. That is a hard concept for some investors to accept. The second hurdle that both advisers and clients have to overcome is the relationship between options and time. Unlike stocks or mutual funds, options have an expiration date. This means that any options investment has to pay off within a certain amount of time or your investment is lost. That can be too much pressure for some clients to deal with, especially those who are accustomed to carrying paper losses for long periods.
Once you overcome these initial hurdles, the world of options can be an enticing place for financial planners. The low cost of options and their high degree of leverage makes them ideally suited for most equity portfolios. While traditional equity investments require your clients to finance entire positions, options allow them to purchase equivalent equity positions at only a fraction of the price.

Another major selling point for options is their ability to serve as hedges for equity and index investments. When a client walks into your office, he is looking for more than stellar returns on his investments. He also wants someone who will safeguard his investments against adverse market conditions. Options are the perfect tool for that scenario. ìOptions are popular with financial planners because of their flexibility,î says William J. Brodsky, Chairman & CEO of the Chicago Board Options Exchange (CBOE). ìThey are the most versatile investment tool that exists for investment advisers and portfolio managers. You can trade them with the stock, without the stock or around the stock. This versatility makes them ideally suited for hedging portfolios and for improving returns on existing equity investmentsî


HOW THEY WORK
Options can be used to hedge portfolios in a number of ways. One of the most popular strategies is selling covered calls. Many financial planners utilize this strategy as a way to kill two birds with one stone. It allows them to protect their portfolios against minor market fluctuations while simultaneously generating revenue for their clients. In fact, this strategy has become so popular that the CBOE has created the Buy-Write Index to facilitate it. This product tracks the selling of covered calls against the S&P 500, allowing financial planners to utilize the covered call strategy without the hassle of rolling their positions forward every month. ìThe Buy-Write index is very important because it links the craze for indexation on the management side with the value of selling covered calls,î says Brodsky. ìThis is a serious product for serious people. It is not a speculative tool. It is a way to manage money with less risk and better returns.î

As appealing as selling covered calls can be, this technique has one significant drawback. It only protects your portfolio against small swings in the underlying. If you want to protect your portfolio against major corrections then you need portfolio insurance (i.e. - puts). Puts can provide your clients with a much deeper level of protection, although that protection comes at a price. Puts must be purchased and rolled forward on a regular basis in order to provide continual coverage. Even though your clientís portfolio may need the protection, they may balk at paying premiums for it. ìClients have a difficult time paying for insurance,î says Kevin Connellan, Director of Equity Trading for Northern Trust. ìItís hard to get it through a clientís head that, sometimes, instead of selling calls against their portfolio, itís smarter to pay for that insurance.î  

BUMPS ON THE ROAD
Getting started in the options markets is nowhere near as difficult today as it was just a few years ago. In 1999, the SEC ended the gentlemanís agreement that existed between the major options exchanges. This agreement prevented the exchanges from listing each otherís products and stealing each otherís market share. If you wanted to trade IBM, then your trade went to the CBOE. If you wanted to trade Intel, then your trade went to the Amex, and so on. Although the SEC ës order was intended to benefit customers by increasing competition, it set off a chain reaction that rocked the industry to its core. Overnight, the options marketplace was plunged into chaos as the exchanges began a long and bloody battle for market share.

Although the competition reduced transaction fees for the customer, it also resulted in a fragmented marketplace that was rife with inefficiency, incompetence and fraud. If you werenít careful, you could easily find yourself the victim of late-fills, trade-throughs or other costly errors. If that wasnít enough to worry about, the endless competition between the exchanges made payment for order flow endemic throughout the industry. Brokers were paid to route orders to a particular exchange, regardless of the price posted by that exchange. ìUnfortunately, the industry is largely structured around payment for order flow,î says Ken Leibler, Chairman of the Boston Options Exchange (BOX). ìIf youíre a market maker on the CBOE, ISE, etc, you pay for the privilege of having an order routed to your exchange. However, the BOX does not pay for orders. In fact, we think the trend in the business is going away from payment for order flow. Weíve set up a market that is not compatible with payment for order flow but is instead more compatible for the customer.î

By 2003, the rampant trade-throughs, inefficiency and fraud finally became too much for the industry to tolerate. In an act of unprecedented solidarity, the exchanges banded together and implemented an electronic linkage system that connected the prices of every major options exchange. Customers no longer had to close their eyes and hope for the best price whenever they entered an options order. Instead, the system would automatically route their order to the exchange with the best price. The system isnít perfect, and problems such as payment for order flow still exist, but it has gone a long way toward bringing the options industry into the modern era. It has also made the industry much more accessible for novice customers, a fact that has spurred the industryís impressive growth rate over the past two years.


To Be Continued in Part Three...
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