The Options Scenario for Hedge Funds

Hedge funds continue to be one of the most dynamic users of both exchange-traded and OTC options, especially in the US, but certain managers could still not be using the opportunity that these instruments can provide them.

Equity-based investment strategies manage hedge funds, which account for a large portion of the equity options market. Several funds focus on the liquid US equity markets and use single stock options, ETF and index options to hedge risk.

Types of Option-Based Strategy

Defensive

Covered put or call options have always been a feature for the long/short equity manager, especially in markets where there is an extensive availability of single-name contracts.

For e.g., in Asia, the choice of single name options is extremely restricted, managers are still dependent on OTC contracts or basic volatility strategies.

The equity hedge fund could use index based puts and calls to economically hedge upside or downside exposure. Managers have been able to concurrently profit from both long and short positions using options. But, it is hard to accomplish constant returns on the short side during an upward-trending market as call selling is not a ‘set and forget’ strategy.

There are extremely sophisticated defensive strategies that regularly make use of options such as hedging tail risk. Hedge fund managers are very careful, as a result of the global financial meltdown in 2007-08. They need to assure investors that the fund is ready for the next black, grey or swan event.

It has also been realized that the value of put options (not only equity puts) collapsed during occurrences of high volatility (e.g. the credit crisis and the flash crash), resulting in more fund managers exploring options as a substitute to defensive cash and Treasury bond holdings.

Covered call selling and yield improvement

The transaction of covered calls by hedge funds is preferred during phases when fund managers are comparatively neutral on the market. This creates premium income and reduces the probable downside exposure of a long underlying position.

One of the major risks with a yield-based strategy is that the holder of the option chooses to exercise it to secure the dividend. Though the best profit and breakeven are understood from a risk management outlook, the possibility of the option being exercised is also extremely quantifiable, with a delta of .95 or above being an excellent benchmark.

There is also a possibility of an early assignment risk for American style options as the long holder of call options could exercise at any time prior to expiration, but most likely when the dividend is more than the excess premium over intrinsic value.

Volatility

Volatility-based strategies make the best use of options, with implicit volatility viewed as one of the most vital constituents of options valuation.

Several hedge funds utilize options to speculate on the direction of implied volatility. For e.g., using CBOE® VIX® options or futures. Since implied volatility itself trades within a dimension that could be described through technical analysis, a fund could focus on the probable buying and selling points specified through traditional price bands.

Arbitrage

Options could be utilized by the activist fund to take advantage of various arbitrage conditions. Volatility arbitrage has progressed from a hedging method to a strategy in its own right. There are a large number of hedge funds trading volatility as a pure asset class.

Essentially, hedge fund options desks could arbitrage options prices on their own, instead of using them to arbitrage other asset classes, using various options recorded on a similar asset to take advantage of relative mispricing.

Dispersion Trades

The dispersion trade has become very prominent with hedge funds that would like to bet on an end to the high-level of correlation between the huge stocks that create index constituents. A fund manager would normally sell options on the index and buy options on the individual stocks comprising the index.

If maximum dispersion happens, the options on the individual stocks generate income, while the short index option loses only a modest quantity of money. The dispersion trade is efficiently going short on correlation and going long on volatility.

The investment manager requires having a proper insight on when such a situation is likely to occur and investors look to focus on data from individual stocks instead of taking a vanilla ‘risk on, risk off’ tactic to equities.

Tail risk funds

It is a fund developed to deliver liquidity in the event of specific risks happening (for instance stock markets crashing by over 20%). It has become a popular portfolio constituent for investors requiring to meet liabilities in the event of market liquidity declining.

Options are a vital asset class used for algorithmic funds because of the increased use of electronic trading for options transactions. One of the important selling points for hedge funds has been the liquidity and operational effectiveness related to exchange-traded options.

Increasingly, hedge funds are implementing weekly options to control positions, allowing successful positions to be developed quickly. They could also deliver competitively priced downside safeguard.

As the options sector continues to develop, further prospects would occur for hedge fund managers.

This would stem not only from the enlargement of the product group available but also from the improved operational effectiveness and transparency delivered by exchange-traded and cleared products. Regulatory demands for a very dynamic marketplace would also play a significant role.

Investment Principles First-Time Investors Should Keep In Mind

Investing is a tricky business. This is especially true for first-time investors. For these individuals, they will often feel that they can never get enough assurance that they made the right decision in choosing the right product or stock they invested in. Most of the time, they will also be worried that they will not gain the return on investment they were aiming for or worse, that they will lose everything that they invested.

But whether you are confident or not about your first foray into the world of investments, as a first-time investor, there are some key, tried-and-tested principles that can help you start and stay on the right track. By following these principles, you will have a higher chance of finding success or, at the very least, contentment in your investment ventures.

Below are some of these important and useful investment principles:

Diversify to spread risks.

One effective way of reducing your risk exposure and increase potential returns in the long run is to spread risks across a wide range of investments. This means holding a mixture of different types of investments which can help cushion your portfolio from downturns. Shares, bonds, cash, and property react differently in varying conditions. As such, opting for more than one asset class can help to ensure all your investments won’t all rise or fall in value at the same time. You can also spread risks through geographical exposure and by going into long-term investing.

Be knowledgeable about all your investments.

Although you may be working with a financial adviser or investment solutions provider, it would always work to your great advantage if you take the time to study and understand the type of investments you have. When you have a good understanding of your portfolio, you minimize the risk being cheated by scrupulous individuals. You can also have a more realistic expectation of what to anticipate in terms of payouts or profits.

Invest for the long-term.

Lastly, it is quite obvious: the longer you invest, the bigger the potential effect of compound performance on the original value of your investment. In general, your investments can benefit from compounding (money multiplying itself by earning a return on the return) if you reinvest any income you receive. As long as you are careful with the types of investments you choose to go into, you won’t go wrong when you invest for the long-term.

Investors Benefit By Finding The Most Up To Date Information

Finding ways to deal with market volatility and minimizing the risks associated with financial transactions can be of paramount importance. Investors who have access to the most complete and up to date financial news are far more likely to make effective and successful decisions. Educational resources, news sources and other assets can play a major role in ensuring investors are met with greater success.

Investing in stocks, bonds and other financial assets can be very profitable. Creating and maintaining an investment portfolio able to provide superior returns often requires a great deal of insight and information. Knowing where to find the latest news detailing the trends and developments shaping financial markets is often the first step in creating a more effective investing strategy.

Novice investors who lack experience in dealing with various markets often require the guidance and assistance that only a professional may be able to bring to the table. Seeking out a brokerage, financial advisor or other industry professional is often a smart move. A little assistance can go a very long way for those who are just beginning to explore the world of finance.

Making frequent trades and investment strategies that require a more active approach may be of tremendous benefit. Lacking insight into financial markets can make it far more difficult to determine the appropriate time to buy or sell stocks and other assets. Investors who have access to the best news and information are far more likely to make the right investment decisions.

Financial journals and other major publications often contain a great deal of useful insight and detailed information regarding major market trends and forecasts. Keeping track of the big picture is always a good idea, even for investors who plan on making multiple trades during a relatively short period of time. Reading up on the latest market news can help ensure that investors are able to make smarter decisions.

Software, applications and other financial services that allow trades to be made more quickly, easily and with less overall cost can also be an important asset. Dealing with a brokerage that takes too long to process a transaction can be a major liability. Investors who plan on adopting a faster paced investment strategy would be wise to ensure they have access to the right resources.

Performing a little research in order to craft the right investment strategy can make a real difference. Making investment decisions without a proper understanding of the market, financial forecast and circumstances may be nothing short of a disaster. Investors who make an effort to prepare themselves in advance are more likely to find success with their efforts.

Access to up-to-date financial news will ensure that investors are able to benefit from a better understanding of their circumstances, options and opportunities. News sites, publications and other resources that allow investors to trade stocks, bonds and other financial assets with greater ease and success can be a crucial asset. Day trading without the right information can lead to increased risks which may result in diminished returns and financial losses.