Who uses Options?
Before trading options, it's important to figure out who uses options. The easiest way to start is by dividing the industry between two sides, the Institutional Investor and the Retail Investor.
The Institutional Investor
This section highlights who uses options on the institutional side:
- Investment Banks
- Hedge Funds
- Mutual Funds
- Market Makers
Investment Banks, which include include Goldman Sachs, Morgan Stanley, Bank of America, and JP Morgan play a significant role in the Options Industry. They commit their own capital and use experts to manage the risks.
These Investment Banks create, package, and then distribute options products to their customers. The customers include insurance companies, investment funds, and retail investors.
Investment Banks are also the largest providers of liquidity for exchange-traded options.
Hedge Funds are the most sophisticated investors in the world. They use investment products that range from stocks to bonds, currencies, swaps, convertible bonds, and options.
Hedge Funds fall into three different Options categories:
- Volatility Trading
- Volatility as an Asset Class
- Directional Leverage
1. Volatility Trading
Volatility Trading involves buying and selling options based on mathematical calculations over a large amounts of trades. This type of trading requires intensive amounts of data, computing power, and expertise.
The Hedge Funds engaged in Volatility Trading include Citadel, DE Shaw, Two Sigma, and Jane Street.
2. Volatility as an Asset
Over the last several years, Volatility has become a focus of institutional investors. These investors are looking for ways to use Volatility products to hedge their overall portfolio.
This greater focus on Volatility has increased the popularity of products like the VIX and VXX.
Hedge Funds and Retail investors also trade these products. In fact, Hedge Funds use these products in creative ways to hedge their portfolio.
3. Directional Leverage
The majority of Hedge Funds use options for the leverage. Whether to protect a stock position, their portfolio, or to maximize potential gains, most Hedge Funds buy options and focus on the “direction” of the underlying asset (i.e. stock).
While Mutual Funds are known for holding a portfolio of stocks, a select few use options. Mutual Funds generally use two different strategies, selling options to generate income and buying options to protect their portfolios.
Corporations use options to buy back company stock.
Years ago, Microsoft was one of the world's largest options users and sold options to a number of the Investment Banks as part of their Corporate buyback program.
In 2015, Home Depot announced an Accelerated Buyback Program with Barclays PLC Investment Bank. The bank structured a product where Home Depot would effectively buy their own stock back by selling options into the market.
Market Makers trade on the exchange floors. Their main function is to be a liquidity provider to the options market. Market Makers trade Volatility similar to the Hedge Fund Volatility Traders described above.
Over the last two decades, computer-driven exchanges (i.e. ISE) diminished the role of the traditional Market Makers on the exchange floors.
The Retail Investor
Now that you know who uses options on the institutional side, it's important to put into context the growing power of the retail side. In fact, options trading volume is now dominated by the average investor.
Today, millions of Americans have better access to stock and options trading apps. This led to record spikes in Brokerage account openings during 2020.
And not only is it accessible, the trading apps are easy to use. This makes retail investors more prone to using options than ever before.
With this influx of retail traders, Options Volume records have been broken over the last 3 years.
Unfortunately, there's a serious problem looming.
At a Disadvantage
In the next few chapters, you'll learn why the available industrywide education is:
- Confusing investors.
I'll show you why it's the education that places the retail investor at a major disadvantage, which will lead to significant losses over time.
Sure, the retail investor understands how to press the buttons to make a trade. However, they fail to understand how to press the buttons in way that gives them a chance at long-term success.