Who Uses Options? A Quick Review of the Players
Investors use options because they are the most important financial tool of our generation. For this reason, every investor, active or passive, should have a clear understanding of the product.
Let's break options down into 3 questions:
- What are they?
- Who uses them?
- How do they profit from them?
This article will focus on how institutions use options in different ways.
Who uses Options?
Options are used by several groups in a variety of ways. Besides retail investors, the main users of equity options on the institutional, or professional, side are:
- Investment Banks
- Hedge Funds
- Mutual Funds
- Market Makers
Investment Banks Use Options
The Investment Banks play a significant role in the Options Industry. A few of the top investment banks are Goldman Sachs, Morgan Stanley, Bank of America, and JP Morgan. They commit a significant amount of their own capital to the industry, and employ teams of experts to manage the risk.
These banks use options to create new financial products, package them, and then sell them to insurance companies, investment funds, and retail customers. These transactions are significant, ranging from $250 million to over $1 billion.
Investment Banks are also the largest providers of liquidity to institutions that trade options. For example, when a Hedge Fund wants to trade 10,000 options contracts, it's an investment bank that often facilitates the trade. These types of trades occur multiple times per day on the trading desks across Wall Street's premier investment banks.
Hedge Funds are considered some of the most sophisticated investors. They use all sorts of investment products ranging from stocks, bonds, currencies, swaps, convertible bonds, and options.
When it comes to equity options, Hedge Funds fall into three categories:
- Volatility Trading
- Volatility as an Asset Class
- Directional Leverage
Volatility Trading involves hundreds, maybe thousands, of options positions. The Hedge Funds involved with this type of options trading are names like Citadel, DE Shaw, Two Sigma, and Jane Street. These funds employ strategies that both buy and sell options in their portfolio.
Institutional investors are now thinking about volatility as an asset class and looking for exposure. Hedge Funds, in particular, have been investing in certain products that reflect the volatility of a particular market (i.e. VIX, VXX). Since volatility generally has an inverse correlation to the direction of the market, these Hedge Funds use volatility products as a hedge to their portfolio.
Lastly, most Hedge Funds use options for the directional leverage they provide. And whether they're protecting a stock position, their portfolio, or using leverage to maximize potential gains, most Hedge Funds buy options.
Mutual Fund portfolios hold many different assets. The well known mutual funds hold portfolio of stocks that target different styles of investing. Examples include aggressive or growth, value funds, or regional funds like Emerging Market funds. However, only a few Mutual Funds use options. Generally, the Mutual Funds that use options use two different strategies. The first strategy sells options to generate income. The second strategy buys options to protect the portfolio.
Corporations use options to buy back company stock. For many years, Microsoft was one of the world's largest users of options. They would sell options as part of a buyback program. In 2015, Home Depot announced an Accelerated Buyback Program that was executed through Barclays PLC Investment Bank. This program was a structured product created by the bank that involved the sale of options.
Market Makers trade on the exchange floors and help provide the options market with liquidity. They are Volatility Traders and act similar to Hedge Fund Volatility Traders. The rise of computer trading has diminished the role of the traditional Market Maker on the exchange floors.
As a Wall Street Veteran, Options Expert, and founder of OptionsGeek, Felix has found a way to simplify options. He's on a mission to close the knowledge gap between the Top 1% and everyone else.