During a catch-up conversation, a now-retired colleague told me how much money he was making by trading options. Based on several recent articles, it seems that he is not alone in looking to Wall Street instruments in hopes of an income boost or a way to hedge uncertainty. In "Retail Investors Flock to Derivatives for Income and Safety" (TheStreet.com, October 31, 2014), senior reporter Dan Freed describes a growing trend in trading options and futures, with growth rates that exceed the level of purchases and sales of stock. On November 3, 2014, the Options Clearing Corporation reported a 22.32 percent rise in total equity and index option volume in October 2014 from one year earlier, "the second highest monthly volume on record behind the August 2011 record volume of 554,842,463 contracts" or a year-to-date volume of 3,673,768,194 contracts.
Reuters journalist Chris Taylor describes the average options trader as 53 years of age, citing Options Industry Council statistics that put nearly thirty percent of those who trade options at between "the ages of 55 and 64." However, in "New baby boomer hobby: trading options" (July 9, 2013), even retirees with a high net worth are cautioned to educate themselves about the downside of leverage. Mary Savoie, Executive Director of the Options Education Program, talks about the free resources made available by the Options Industry Council.
Critics counter that formal training cannot replace experience and that retirement assets should be invested with a long-term goal in mind, especially for those individuals with a low net worth. What they may not realize is that numerous retirement plans are chockablock with exposure to derivatives in the form of investment funds that trade swaps, options and futures. In mid-September of this year, Bloomberg reporters Miles Weiss and Susanne Walker wrote that then PIMCO senior executive and co-founder of the Pacific Investment Management Company Bill Gross "sold most of the $48 billion of U.S. Treasuries held by his $221.6 billion Pimco Total Return Fund (PTTRX) in the second quarter, replacing them with about $45 billion of futures. In "SEC Preps Mutual Fund Rules," Wall Street Journal reporter Andrew Ackerman (September 7, 2014) cites a concern on the part of the U.S. Securities and Exchange Commission about the use of derivatives by certain mutual funds and could seek "to limit the use of derivatives in mutual funds sold to small investors, including both alternative funds and certain 'leveraged' exchange-traded funds, volatile investments that use derivatives to double or even triple the daily performances of the indexes they track..."
Over the years, I have traded derivatives, valued derivatives, reviewed financial models, created hedges and stress tested deals for compliance purposes. Throughout that time, the global markets continue to grow, attesting to their popularity. Earlier this summer, the Bank for International Settlements measured the over-the-counter derivatives market as having expanded to outstanding contracts with a value of $710 trillion at yearend 2013, up from $633 trillion in a single year.
Whether singular derivative transactions are appropriate for any one individual plan participant depends on a number of factors. Suffice it to say, derivative instruments are here to stay. It would be incorrect to underestimate the ubiquitous nature of derivatives. Besides asset managers who use derivatives, there are plenty of structured products that layer in derivatives with traditional equity or fixed income securities.
Stay tuned for more from the regulators about the usage of derivatives and asset management. In the aftermath of the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, rules about derivatives trading and clearing are changing the operational and technology landscape. Fund directors not already in the know are being urged to pay attention to the economic impact on fund activity when derivatives are used. Click here to download a good risk management checklist. It is part of a November 8, 2007 speech by Gene Gohlke, then Associate Director, Office of Compliance Inspection and Examinations, SEC. Entitled "If I Were a Director of a Fund Investing in Derivatives - Key Areas of Risk on Which I Would Focus," Attorney Gohlke addresses the panoply of due diligence considerations such as custody, pricing and valuation, legal, contractual, settlement, tax, performance calculations, disclosure, investor reporting and compliance. These are important knowledge areas for investors too.