Why options are all the rage suddenly

Why options are all the rage suddenly
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First Published: Tue, Sep 23 2008. 12 59 AM IST

Updated: Tue, Sep 23 2008. 12 59 AM IST
The Indian markets have taken to options trading like never before. September is all set to be the first month when more index option contracts have been traded than index futures. August came close, when the number of index option contracts that changed hands were just 4% lower than the trading in index futures. Just in January this year, the difference was as high as 75%.
With the markets correcting sharply since and with volatility rising, it’s understandable why options trading has become increasingly popular. More traders want to limit losses, buy protection against major market moves and also participate in the market without risking much. But the extent of the rise in volumes has taken experts by surprise. Compared with a daily average of 250,000 contracts in May, nearly a million index option contracts are now being traded daily. It is not that this increase is coming at the expense of index futures trading. This segment averaged 700,000 contracts in January and 560,000 in May. So far this month, average daily volumes are 876,000 contracts.
Also See Changing Profile (Graphic)
The chart above shows that volumes jumped sharply in June, even before the first DMA (direct market access) trades hit the Indian market in mid-July. As the use of DMA and algorithmic trading picks up, options trading will benefit the most. Since numerous options at different strike prices and maturities trade in the market, it is impossible for a trader to keep track of pricing inefficiencies between these. An algorithmic program would not only spot such trading opportunities, but also release orders into the trading system with the DMA facility.
Traders point out that the recent surge in interest in options has to do with favourable tax treatment, lower brokerage and sharp market volatility. Traders now have to pay brokerage only on the option premium, compared with the earlier practice of paying brokerage on the notional value of contract (that is, strike price plus premium). This results in considerable savings when compared with an index futures contract of an equivalent size. This year’s Budget also changed the treatment of securities transaction tax on option contracts, which, in a similar fashion, makes options positions most cost effective. Of course, the introduction of long-dated options earlier this year has also added to volumes. Besides, an option buyer’s risk is limited to the premium paid, but with futures, the trader’s risk is unlimited. With the markets at times opening 3-4% higher or lower, futures traders carry high risk.
But the pertinent question is, who’s writing all these additional options? Most traders would be happy buying options, given the defined risk and the unlimited profit potential. The trick is to find an equal and opposite set of option writers who carry unlimited risk in exchange for just the income from the option premium. Globally, this task is performed by professional investors (read institutional investors), who may be sitting on idle stock and may want to earn extra income on it. These investors also hedge their bets by taking opposite positions in either other option contracts or the futures market. Along with proprietary desks of both Indian and foreign brokers, institutional investors are the most active options writers even in India.
But traders point out that even some retail traders (mostly high net-worth individuals) are active in writing options. Besides, there are a handful of dedicated options desks, where a few professionals raise capital and deploy the funds in the options market. The difference between the Indian and developed markets is the presence of non-institutional players in writing options. Perhaps the only other place where the retail category takes such risks is the South Korean market, whose Kospi 200 option contract is the top exchange-traded derivatives contract in the world.
Indian traders are generally known to be risk-tolerant, which is reflected in their high share of 55-60% in the equity derivatives market. In most other markets, retail participation is restricted to buying options, where the risk is limited. Our retail players write options, take long and short positions in the futures market—each of which entail enormous risk. Should the market regulator be worried? At the exchange level, there is little risk because of the stric margining system followed. But at the broker level, the experience in January shows that inadequate margin collections from retail clients lead to huge losses. Unless brokers have learnt their lessons, there could be a repeat of what happened earlier this year with single-stock futures.
In The Money runs every other Tuesday. We welcome your comments at inthemoney@livemint.com
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First Published: Tue, Sep 23 2008. 12 59 AM IST
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