The enormous recent growth in options trading has mostly been focused on retail traders, but the use of options has also been growing among “’40 Act” funds, which are SEC-regulated funds governed by the U.S. Investment Company Act of 1940. These include ETFs, mutual funds, and closed-end funds, according to Matt Moran, head of index insights at the Cboe Options Institute. He spoke, along with three other industry experts, in a webinar from the Institute on Wednesday Jan. 26 and in a separate interview with John Lothian News in advance of the webinar. Many of these funds, including those offered by First Trust, Calamos, and Innovator, are based in or around Chicago, Moran said. They do not include hedge funds, which are somewhat less regulated, and most of these funds use fairly conservative strategies, he added. Many of the new options-based funds use target income or buffer protect strategies. Cboe Global Markets has some benchmark indexes for these strategies, with which fund managers may strive to eliminate 10% of an investor’s downside risk. Particularly in Europe, structured products were offered by banks to individual investors. These ’40 Act funds are attempting to provide structured outcomes to the masses through products like ETFs, rather than having to go to a bank. “A lot of the advisors say options are still pretty labor intensive. They ask, ‘Can you give me a packaged product that can do the job for me?’ This has led to a growing use of fund products to give people options exposure,” Moran said. Keith Black, managing director and program director for the FDP Institute, is an academic and a former trader and consultant to institutional investors. He and a colleague, Professor Edward Szado, did a recent study that found that in 2000, only 10 ’40 Act funds used options predominantly in their strategies, but that grew to 157 funds in 2017 (and according to Cboe estimates, that number grew to 280 funds in 2021). Options strategies such as buy-writes, where you are long stock and short calls, collars (short calls and long puts) and cash-secured put-writes, on average have a beta of between .6 and .7, “maybe ⅔ of the S&P 500,” Black said. They perform particularly well in a down market; the strategies can generate income from premiums while also offering some downside protection, he said. He added that of course in a runaway bull market any long puts or short calls will underperform the equity markets. Not all strategies work in all environments, said Joe Cusick, VP Portfolio Specialist at Calamos Investments, and environments are changing rapidly right now. Calamos, which currently manages about $44 billion, offers 18 open end funds in the ’40 Act space and 7 closed end funds, Cusick said, the majority using some sort of overlay approach. From the basic components of selling calls, buying puts and selling puts, “We also use some of the core indexes Matt was referencing, such as the PUT index and the BXM index, which are great when talking to advisors to give them benchmarks.” These fund advisors need a benchmark to give them a focal point to set their expectations, Cusick added. He also said Calamos does not have a “set it and forget it” attitude. “If it goes a certain point to the downside you will start losing one for one. We’ll actively manage the strategies, specifically long and short puts on the downside with no leverage. We want to leave as much runway to the upside as possible, in other words we’re buying calls and selling calls, so as the markets naturally drift to the upside, we’ll be prepared, and we won’t have caps.” It is important to look at how a fund does in a down market and in a recovering market, Cusick said. “If you actively manage your strategies based on being in the right regime and the right business cycle, and have risk adjusted returns, you and your clients have the potential to be successful,” he said. Cusick was on the team that built OptionsXpress, which was “the most disruptive online brokerage company to date,” he said; it ultimately sold to Schwab. Individual traders got the ability and tools to trade options much earlier than institutions did, he said, “but now we’re seeing the rise of the institutions.” In 2006 institutional trading moved away from equities, fixed income and cash instruments and started allocating to alternative vehicles. The reason for that is that diversification using traditional products has been very difficult, Cusick said. For example, with zero percent interest rates “the ability to park into Treasuries and get an attractive risk free rate has diminished quite a bit.” Part of the “rapidly changing options environment” is the changes in the levels of the Cboe Volatility Index (VIX). The VIX index is currently in the mid-20s, “which would historically have seemed high, but for the Covid-19 era the mean is actually 23,” Cusick said. The differences between the VIX index vs. historical volatility can be significant and that phenomenon can facilitate a lot of options selling strategies, Matt Moran said. And options selling strategies in these funds have generally had a higher return than options buying strategies, he added. Also, there are tremendous differences in implied volatility for various options – some of the out-of-the-money index puts are at much higher volatility levels than at-the-money or out-of-the-money calls. So there is a lot of difference in the volatility skew, Moran said. “You might think the markets are getting more efficiently priced, but we had record highs for the Cboe SKEW Index. In 2021 the skew averaged 145.9, much higher than the previous record of 134.8, which is a very big deal for people trying to identify opportunities in the options markets,” he added. Cboe offers a number of different options benchmarks that show the performance of various strategies starting in mid-1986, he said. “Many investors are looking for lower standard deviations and lower betas.” Blair Hull, the founder and former chairman of Hull Trading, said the increased use of options has actually created more options mispricing. Index puts are overvalued, for example. “People need to buy insurance to protect their portfolios, but they are creating some mispricing.” Some of the mispricing is due to retail investors and “Robinhood players” as well as buy-write funds and investment advisors selling calls to improve income for investors. And some is from corporations buying back their stock, who often then sell puts, Hull said. “Options in general tend to be overpriced. People like to be long options rather than short options,” he added. High dividend stocks tend to be slightly underpriced because people are doing a lot of buy-writes. Why do people buy overpriced options and sell overpriced options? Hull said his hypothesis is that it’s very tricky to construct a portfolio that will gain maximum returns while also controlling risk in an options strategy. He said he is using some of the machine learning techniques Keith Black is teaching in his school to figure out where options are mispriced. Hull Tactical Asset Allocation, LLC, which Hull created in 2013, started using options in its actively managed ETF a few months ago, Hull said. The Hull Tactical ETF seeks to maximize value compared to risk, he said. “Options will continue to be mispriced, but it’s difficult to take advantage of this,” he added. “The funds that do this will help create a more efficient options market.” Cusick said the ETF space is taking what was in the ’40 Act space and continuing to grow it. “Some restrictions are lifted in ETFs. The biggest thing is that institutions are realizing you can do the same thing with an options strategy vs a traditional product,” he said. Having the technology and the education to trade these products really helped the institutional use of options strategy funds take off, Cusick added. “Everyone is now realizing that whatever you can do with a product – a fixed income, a private equity, even a commodity – you can develop an options strategy that can provide similar returns or meet the problem you’re looking to solve.” A replay of the 80-minute webinar is available HERE. From today's John Lothian letter.