The New York Post is not normally the first place you'd turn for articles about RiskMetrics. On March 8, however, columnist John Dizard mocked Morgan’s risk management systems for failing to predict the $587 million fourth quarter earnings loss the bank holding company designated as “nonperforming assets, primarily swaps.”
The problem, claims Dizard, goes to the heart of the bank's ability to control risk. Instead of chasing the retail credit card businesses like other banks, he explains, Morgan decided to take the less traveled road and become a global derivatives player. “There was, however, a reason that this road was less traveled by—it was studded with land mines.”
RiskMetrics, he says “uses the same probability theory analysis that a serious gambler would employ in estimating his risk/reward ratio—Morgan may have ordered RiskMetrics from the same Acme Co. that used to supply Wile E. Coyote with those rocket-powered roller skates.”
He goes on to quote an unnamed source on the merger rumors swirling around the bank. “I think of them as pink, trembling aristocrats worrying about how their cruel new barbarian masters will use them,” says the source. “They want to be rescued by someone like Deutsche Bank, but Deutsche doesn't need the name. Someone with a lot of money and not so much class will move in.” By now everyone has heard that 1997 was a record year for most major options exchanges. But many would be surprised to learn that much of that growth was fueled by individual stock options, as opposed to index options, despite the success of new listed index products such as the Chicago Board Options Exchange’s options on the Dow Jones Industrial Average.
How to explain the relative success of equity options? Let Goldman Sachs count the ways. In two recent research reports, “U.S. Stock Options Move to Center Stage: A Look Behind the Scenes,” and “Relative Value in U.S. Stock vs. Index Options: Is Dispersion Cheap?” Goldman researchers explain why equity options have soared, and what investors should do about it.
In the past three years, stock option activity has increased at an annual rate of more than 20 percent. A number of developments point to continued success of equity options. The growth of hedge funds with a stock focus, in which managers use stock options to leverage equity views and to implement bearish views with more precision than index options, has had a profound effect. In addition, a more subdued equity market, which Goldman believes is in the offing, should place additional emphasis on stock selection more than overall market performance. There has also been an increased desire on the part of wealthy investors to hedge the capital gains they have realized in concentrated stock funds, and an increasing prevalence of stock options in employee compensation structures, which increases general familiarity of equity option products. The bustling long-term equity anticipation securities (LEAPS) market has contributed as well, allowing investors to take longer views on particular equities.
The report also points to an increasingly beneficial regulatory environment, including wider position limits for those using the equity hedge exemption, the removal of position limits on equity FLEX options and the Securities and Exchange Commission’s move to model-based capital requirements for listed broker-dealers.
In addition, changes to the tax law, such as the elimination of the short-short rule, have made options more tax-advantageous to investors. Goldman also argues that there has been an increasing acceptance of derivatives in the financial world, and that an increase in corporate restructurings has enticed many investors to use options to speculate on potential merger and acquisition activity.
As if that weren’t enough, Goldman asserts that the volume of calls as a percentage of total volume has hovered around 70 percent for equity options, whereas it has struggled to reach 50 percent for index options. This indicates that while investors use equity options for leveraged investments, they use index options primarily to hedge their broad-based exposures. “In light of the strong U.S. equity market returns in the last few years,” says Goldman, “such index option strategies may have fallen in the shadows…As growth of the U.S. market slows to a more ‘normal’ pace [this year], stock selection and sector rotation are likely to become of increased importance.”
But how can investors capitalize on this trend? Goldman notes that “the spread of stock option to index option volatility was in a general trend of widening during the early 1990s as implied index volatility fell sharply and stock option volatility was stable. Since mid-1994, however, the spread has narrowed and may now be poised to begin another multiple-year rising trend as bottom-up forces that emphasize stock selection gain in relative importance.” Further, correlation is poised to decrease, says Goldman, so stock option strategies are preferable to index option strategies “to capture any increase in the dispersion across stock returns.” With this in mind, Goldman offers three possible strategies for investors:
The problem, claims Dizard, goes to the heart of the bank's ability to control risk. Instead of chasing the retail credit card businesses like other banks, he explains, Morgan decided to take the less traveled road and become a global derivatives player. “There was, however, a reason that this road was less traveled by—it was studded with land mines.”
RiskMetrics, he says “uses the same probability theory analysis that a serious gambler would employ in estimating his risk/reward ratio—Morgan may have ordered RiskMetrics from the same Acme Co. that used to supply Wile E. Coyote with those rocket-powered roller skates.”
He goes on to quote an unnamed source on the merger rumors swirling around the bank. “I think of them as pink, trembling aristocrats worrying about how their cruel new barbarian masters will use them,” says the source. “They want to be rescued by someone like Deutsche Bank, but Deutsche doesn't need the name. Someone with a lot of money and not so much class will move in.” By now everyone has heard that 1997 was a record year for most major options exchanges. But many would be surprised to learn that much of that growth was fueled by individual stock options, as opposed to index options, despite the success of new listed index products such as the Chicago Board Options Exchange’s options on the Dow Jones Industrial Average.
How to explain the relative success of equity options? Let Goldman Sachs count the ways. In two recent research reports, “U.S. Stock Options Move to Center Stage: A Look Behind the Scenes,” and “Relative Value in U.S. Stock vs. Index Options: Is Dispersion Cheap?” Goldman researchers explain why equity options have soared, and what investors should do about it.
In the past three years, stock option activity has increased at an annual rate of more than 20 percent. A number of developments point to continued success of equity options. The growth of hedge funds with a stock focus, in which managers use stock options to leverage equity views and to implement bearish views with more precision than index options, has had a profound effect. In addition, a more subdued equity market, which Goldman believes is in the offing, should place additional emphasis on stock selection more than overall market performance. There has also been an increased desire on the part of wealthy investors to hedge the capital gains they have realized in concentrated stock funds, and an increasing prevalence of stock options in employee compensation structures, which increases general familiarity of equity option products. The bustling long-term equity anticipation securities (LEAPS) market has contributed as well, allowing investors to take longer views on particular equities.
The report also points to an increasingly beneficial regulatory environment, including wider position limits for those using the equity hedge exemption, the removal of position limits on equity FLEX options and the Securities and Exchange Commission’s move to model-based capital requirements for listed broker-dealers.
In addition, changes to the tax law, such as the elimination of the short-short rule, have made options more tax-advantageous to investors. Goldman also argues that there has been an increasing acceptance of derivatives in the financial world, and that an increase in corporate restructurings has enticed many investors to use options to speculate on potential merger and acquisition activity.
As if that weren’t enough, Goldman asserts that the volume of calls as a percentage of total volume has hovered around 70 percent for equity options, whereas it has struggled to reach 50 percent for index options. This indicates that while investors use equity options for leveraged investments, they use index options primarily to hedge their broad-based exposures. “In light of the strong U.S. equity market returns in the last few years,” says Goldman, “such index option strategies may have fallen in the shadows…As growth of the U.S. market slows to a more ‘normal’ pace [this year], stock selection and sector rotation are likely to become of increased importance.”
But how can investors capitalize on this trend? Goldman notes that “the spread of stock option to index option volatility was in a general trend of widening during the early 1990s as implied index volatility fell sharply and stock option volatility was stable. Since mid-1994, however, the spread has narrowed and may now be poised to begin another multiple-year rising trend as bottom-up forces that emphasize stock selection gain in relative importance.” Further, correlation is poised to decrease, says Goldman, so stock option strategies are preferable to index option strategies “to capture any increase in the dispersion across stock returns.” With this in mind, Goldman offers three possible strategies for investors:
- Favor option positions that are long volatility on extremely attractive or unattractive stocks. Replace or augment stock positions with call options or call spreads (long at-the-money call/short out-of-the-money call) as a way of capturing the upside of value-added stock selection while limiting downside exposure.
- In buying stock options vs. sector options, be sensitive to sectors where innovation or market developments shift the returns across participants dramatically, as in technology and consumer nondurables, where competition is intense.
- Favor short or neutral volatility positions in index options for risk management by selling out-of-the-money call options at target index levels or using long put/short call strategies for downside hedging.
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