Trading in stock-index options: risky for many; good tool for pros

A game for the swaggering, diamond-ringed high rollers. A one-shot stab at big bucks. That's the picture many investment managers had when stock index options debuted in the spring of 1983. Nowadays, more and more portfolio managers and speculative traders are dipping a toe, if not plunging head first, into the options market.

``It's still relatively new, but I think you'd be hard pressed to find a portfolio manager that hasn't used or isn't planning to use index options,'' says Wayne Wagner, chief investment officer at Wilshire Associates, a Santa Monica, Calif., money-management firm. Other sources estimate at least 25 percent of portfolio managers are using options.

Traders are flocking to one index in particular -- the Standard & Poor's 100. This popular options basket of blue-chip stocks is traded on the Chicago Board Options Exchange (CBOE). Since its inception in March 1983, trading volume has soared -- even while the stock markets languished last year. And in January, when the rest of the markets skyrocketed, option trading continued to surge. The average daily options trading volume on the S&P 100 hit a new monthly high.

Of course, success breeds clones. The second most popular options bundle is the major-market index, consisting of 20 large companies listed on the American Stock Exchange. New indexes, including baskets of stocks in specific industries such as oil or technology, are blossoming -- and wilting -- rather routinely now. Most major exchanges carry at least one options index.

For individuals without a large portfolio, index options are basically a speculator's game -- little more than a bet on the direction of the market. An expensive lottery ticket.

``Your downside risk is limited [to the purchase price and commission fees] and the upside offers the chance at a big hit,'' explains Franklin Edwards, director of Columbia University's Futures Center.

There are similarities between options and gambling, Mr. Edwards concedes, but there are some ``important distinctions. You have to ask: Does it increase social welfare? There is no doubt that speculative activity adds liquidity to the market, making it cheaper for people to shift risk, and thereby making it cheaper to finance socially redeeming activities.'' Pure gambling has no socially redeeming value, it creates risk only for the sake of having fun, Edwards says.

The following example illustrates how one might make an index option trade:

Suppose the S&P 100 index is at 170 on Feb. 25 and the stock market has been in the doldrums. You think the S&P 100 might rise beyond 170 by March 15. So you buy one March call option and that day the premium (price) is trading at 11/2. Your cost is 100 times 1.5, or $150, since the value of the contract is calculated by multiplying the premium by 100. If, on March 5, the market takes off and the index hits 180, then a March call option might be trading at 4. So if you sold it (someone else buys it who thinks the index will go even higher), you'd get $400 (100 times 4). Subtract your initial $150 premium and subtract commission fees (perhaps $50): You end up with $200 in profit. If the market doesn't go beyond 170 and you don't sell your option by the March expiration date, you're out the price of the option, $150.

Money managers are seizing upon index options, not for speculative thrills, but for the distinct, new advantages offered by this trading tool.

Primarily, portfolio managers are using options to hedge or insure a stock portfolio against loss. Market swings of 35 points in a day were unheard of not too long ago. Now such fluctuations are commonplace, and index options help managers cope with the quick swings.

David L. Caplan, head of options trading at Jessup & Lamont Securities Company in Los Angeles, ``Options used to be a more speculative vehicle. But a portfolio today that's not hedged with options is in fact a more speculative portfolio.''

If it weren't for options, a money manager with a mix of stocks that are dropping in price might just have to dump those stocks. But with an option on an index that matches his own portfolio of stocks, the money manager can, for example, buy a put and the put can make money while the stock prices fall. Thus, it's cheaper than selling off his position in the slipping stocks, and it means the value of the portfolio doesn't change: The drop in stock prices is matched by the rise in value of the option. Also, it's cheaper and less risky (the premium is the most that can be lost) than selling the stocks short or buying individual stock options corresponding to the portfolio.

(The popularity of index options has taken some of the wind out of the sails of options on individual stocks. Apparently many traders are switching to index options, so volume in single stock options has fallen in the last few months. The result: reduced liquidity -- having fewer traders makes it harder and more expensive to buy or sell individual stock options.)

Index options also give money managers a less cumbersome and less expensive way to get into the market quickly when it takes off -- an important asset in light of the explosive nature of recent rallies.

Finally, some money managers and brokerage traders use the index to do some intermarket arbitraging. Using computers and plotting a theoretical value for an options price, they buy and sell big blocks of stocks and options to take advantage of discrepancies between prices for the underlying stocks and the prices of the index options.

And if such traders buy a call option just before they go on a buying spree of the stocks in the index, they can make money, because the index moves following their purchases. Or when these arbitragers are ``unwinding'' their positions -- selling off those stocks and options -- they similarily make a profit. Some brokerage houses and institutional traders can throw around huge amounts of capital, so the effect of their combined actions may nudge the index one way or another.

But this kind of trading has elicited cries of ``foul'' from some options traders. On the third Friday of the month (the last trading day before an option expires), particularly in the last hour of trading, there have been wild fluctuations in the stock market. One trader quoted in Barron's magazine called it a case of the tail wagging the dog: ``The futures markets are jerking around the stock markets.''

An options trader in New York, who asks not to be identified, says: ``I think you've got a group of participants moving the market at will. . . . They'll brag about how the market doesn't move without them.''

Since the public or even other traders may not be aware of when these arbitrage moves are going to happen, they can be the ones that lose money. ``This is a zero-sum game,'' the New York options trader says. ``If the big trading desks are winning, somebody has to lose, and the public or institutions not following the [brokerage] desk must be the losers.'' He says the situation has caused him to curtail his own options trading.

Last April, sharp market and options gyrations at expiration time prompted charges of ``front running'' -- an illegal tactic of buying options based on inside knowledge of someone else's planned trade of a block of stocks. This charge brought about an investigation by the New York Stock Exchange and the CBOE. The conclusion was that it is not illegal for a trader to front-run his own trades; the tactics are simply part of a legitimate arbitrage strategy. A CBOE spokesman, however, says steps are being taken to ``educate the trading public to the potential dangers on expiration day.''

A major study on options by the Securities and Exchange Commission (SEC), the Federal Reserve Board, and the Commodity Futures Trading Corporation was released last month, entitled ``A Study of the Effects on the Economy of Trading in Futures and Options.'' It concluded that futures and options ``appear to have no measurable negative implications for the formation of capital'' and arbitrage trading ``does not appear to have resulted in significant harm to public customers.''

According to Dennis Shea, SEC assistant director of surveillance, the agency is taking a wait-and-see approach. ``We're mostly at the monitoring stage to determine the extent of the problem. It is something that seems to be growing, but sometimes this type of thing develops, then goes away. As everyone discovers the strategy, it no longer works, and the aberrations disappear.''

Or as John Fullerton, portfolio manager at Boston Company Institutional Investors Inc., says, ``The dog is now ready for the movement of the tail.''