The continuing COVID-19 pandemic and the resulting economic crisis has global investors turning to the derivatives market in droves to lock in gains and hedge against losses.
Global futures and options trading rose 32 per cent in the first half of the year compared with the same period in 2019 to a record-setting 22 billion contracts, according to the Washington-based Futures Industry Association (FIA). The FIA tracks futures, options and other derivatives trading activity on more than 80 exchanges worldwide.
“What the data demonstrate is that there was a very large increase in turnover in the first half of the year as market participants reacted to the impact of the pandemic on global economic activity,” says Will Acworth, senior vice-president, publications, data and research, at the FIA.
The biggest spike in derivatives trading occurred in the first quarter, with the onset of the pandemic and subsequent economic lockdown, but Mr. Acworth says derivatives investors have become more selective as it becomes apparent some sectors are weathering the storm better than others.
“Some markets have continued to have very high levels of turnover. Other markets have settled down. It varies,” he says.
For example, some investors are hedging against losses in hard-hit commodities-related equities while others are attempting to lock in gains from high-flying technology stocks such as Facebook Inc. (FB-Q), Apple Inc. (AAPL-Q) and Microsoft Corp. (MSFT-Q). That helps explain why investors are buying call options, which gives them the right but not the obligation to purchase stocks at a certain price, at historical rates. In other words, they benefit if technology stock prices continue to rise but can avoid losses if they fall.
Derivatives are like insurance policies covering all asset classes, including equities, currencies and interest rates. Most are traded by large institutional investors, but more retail investors are turning to them in their registered retirement savings plans and tax-free savings accounts as trading platforms become more sophisticated and a larger segment of the population needs to protect their retirement savings from turmoil in equities markets.
Richard Croft, president and chief investment officer at Toronto-based R.N. Croft Financial Group Inc., says derivatives trading has become a bigger part of his business as clients seek shelter from market volatility.
A popular strategy for investors looking for an income stream that dovetails with other income strategies such as fixed income, preferred shares and real estate investment trusts is writing covered calls on stocks they already own, he says.
“It’s always a decent strategy. Call option writing has historically produced positive risk-adjusted returns for the past 30 years,” Mr. Croft says.
The writer or seller of a call option gives the buyer the legal right – but not the obligation – to buy shares in the underlying stock at a set price, known as the strike price, any time on or before a set date. If the stock rises above the strike price, the owner will likely be forced to sell at the strike price. If the stock remains below the strike price, the writer keeps the stock, any dividends it generates and a premium paid by the buyer.
“Options actually gauge risk, so you’re actually capturing the two sides of the investment coin: the underlying security and the option,” Mr. Croft says.
As many derivative investors on the other side of the trade are buying call options to protect gains in high-flying technology stocks, Mr. Croft says call writers are being rewarded with bigger premiums.
“Options reflect the risk in the market. Option premiums are a little higher than normal right now, so it’s a decent time to write options,” he says, adding that liquid stocks with big runups, such as electric car maker Tesla Inc. (TSLA-Q), are his favourites for covered call writing.
“I would always write an option on Tesla because I think that [stock] is way out in left field,” Mr. Croft says.
Balancing the risk with the reward when investing in derivatives can be difficult for the average investor. Luke Rahbari, chief executive officer of Chicago-based Equity Armor Investments LLC, uses them as hedges on behalf of large, institutional investors.
“You need to know how much of a hedge you need to put on, how much protection you’re getting, what the correlation to your assets are with that hedge, and when to take it off,” he says.
Mr. Rahbari’s specialty is the Chicago Board Options Exchange’s Volatility Index, commonly known as the VIX, or the fear gauge. The VIX uses futures contracts on the S&P 500 as a real-time gauge of expected price fluctuations over the following 30 days.
In March, at the height of market fears over the pandemic, the VIX spiked to 80 from 14 in just one month. It has since retreated to under 30, signalling to Mr. Rahbari that markets have not fully factored in the risk of the second wave of the pandemic combined with growing uncertainty about the U.S. presidential election in November.
“Things are going to be really volatile,” he says, adding that much of the complacency comes from a misguided belief that central banks will continue to flood the markets with financial support.
“Everybody thinks the [Federal Reserve Board] is going to come in and save the day,” Mr. Rahbari says. “The question you keep having to ask yourself is: ‘What if the Fed wasn’t here? Where would the market be?’”
Exchange-traded funds that track the VIX are available for retail investors who want to profit from volatility, whether stock markets spike up or down, but Mr. Rahbari warns they could backfire if markets flatline.
“If you are going to use a hedge, you should have a professional do it for you,” he says.