Equity Options in Hedge Funds
Hello,
I am Senior undergraduate studying finance. I trade equity options primarily though short premium strategies. I don't have much knowledge about hedge fund activities.
Do hedge funds use exchange-traded (not OTC) equity options for any purpose other than hedging? If so, how frequently? For example, lets say you're a hedge fund and you do your DD and you think Apple is worth $170/share and will be at that price in Jan 2019 (Price at time of writing is $183.83). You could short the stock (100 shares), maybe pay a borrow fee, and hope it goes down to 170. When it hits 170, you buy back your shares for a profit of $1383. Assuming a 50% margin requirement, (which I am not sure hedge funds have), the return would be 1383/9195.50=15.03%. Let's say they sold the 185 call in Jan2019, which currently trades for 13.12 mid price per share. If the stock stays below 185, which they believe will happen by Jan2019, and the margin requirement for retail traders is about $3580, (could be less for hedge funds) the return would be 1312/3580, or 36.64% and a higher probability of success is greater than shorting the stock because they are profitable up to an AAPL share price of $198.11 in Jan19, whereas the short position would be a somewhat sizable loser at those levels. I understand that option success is more based on timing than traditional "value long and short" strategies, and that may make people uncomfortable, but in an industry where one is judged partially on annual returns (shorter-term), options may be the most efficient use of capital. Furthermore, the liquidity in equity options could be another factor. Hedge funds manage huge amounts of capital and there are only roughly 10,400 of that Jan2019 185C for a total value of $13,644,800 and AAPL one of the most liquid underlyings with relatively high option prices, compared to a $40 stock for example.
So I'm just curious if they do utilize them for applying their assumptions into trading strategies, or use options for hedging risk only. If they do use it solely for hedging risk, how frequently do they do that as well?
Thanks!
Well, who do you think buys your short premium trade and why?
I've talked to guys at option market making firms that say they are almost always long a ton of premium from filling market participants' orders. They buy it for the efficiencies that come along with the scale in which they trade/make markets and the improved chance of success based on the increasing number of occurrences. Could you provide a little more detail?
On the topic of hedge funds using options - of course hedge funds do use options. There are 3 major uses for options -leveraged directional plays, hedging (usually with options on indices or ETFs) and volatility arbitrage (which is what your's truly does for a living).
With regards to your questions, I would suggest that you actually read up on the mechanics of the options trading (primarily the concept of risk neutrality and delta-hedging) That would give you an insight into how an options market-maker makes money. Once you have a better idea, you would realize that no "guys at option market making firms" would ever use the word "premium".
As Mostly Random Dude mentioned, you can lever up and reduce potential downside with options - while a short position could have unlimited loss, an option position only risks the premium in this situation. Pershing Square used this strategy when they converted their naked short position in Herbalife to put options.
Depends on the strategy.
Equity L/S, index or single name hedging, yes, but also if perhaps there is a name with a very binary event coming up - and they want the upside exposure without the downside potential, then they might consider using an option structure (naked vanilla or something more complex) to capture the upside with a known downside.
A global macro fund may take directional bets using options on indices or bespoke equity buckets,
Or there are your long-vol/short-vol HFs that might be buying or selling butterflys (again, single-name, index or bespoke bucket) in order to make bets on the volatility regime in the short, medium or long term. Long-vol funds are primarily used as tail-protection products and many are systematic, but because they can be very actively managed to reduce any bleed, or create a neutral carry, they are considered HFs (plus you gotta pay the 2/20)
I'm not too big on my greeks etc but Im basically trying to say yes, yes HFs use options all the time
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