The surge in index options trading in India is nothing short of revolutionary. A little before the market bubble burst in January 2008, about 180,000 index options contracts traded daily on the National Stock Exchange, accounting for about one-fourth of all trading in index derivatives. In the past two months, daily volumes in this segment have averaged 1.58 million contracts, a jump of 775%. They now account for about 60% of the index derivatives market and about 40% of the entire equity derivatives market.
While the index futures market has lost significant share in this period, its volumes have doubled to a million-plus contracts. So, the exponential growth in the index options market hasn’t come at the expense of dwindling volumes in the futures market. It has, instead, led to an expansion in the entire market for index derivatives.
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Volumes in these markets rose sharply since mid-2008 because of two main reasons. One, a change in regulations meant that option writers had to pay securities transaction tax (STT) only on the option premium, compared with the earlier practice of paying brokerage on the notional value of the contract (strike price plus premium). Similarly, the cap on brokerage charges was redefined. Earlier, it couldn’t exceed 2.5% of the notional value of the contract; now, it can’t exceed 2.5% of the option premium.
Also See Growth Surge (Graphic)
These changes resulted in sharply reducing transaction costs for index options. For instance, if a Nifty option with a strike price of 4000 and a premium of 100 is traded, the brokerage and STT would be calculated only on the premium of 100, compared with the earlier practice of using 4100 (strike price plus premium) as the base for these calculations.
Could the fall in transaction costs have led to erstwhile futures traders shifting to the options market? One way to answer this question is to compare the cost of a plain vanilla futures position with that of a synthetic one created by trading two options contracts. For instance, a short call and a long put position will have the same payoff as a short futures position. According to an institutional derivatives broker, while brokerage charges vary depending on clients, the cost of a synthetic futures position will not be much lower than a vanilla futures position. Although the brokerage in the case of options is charged only on the premium, the fact that the two transactions have to be executed in sync will entail a comparable, if not a higher, cost than executing one trade in the futures market.
This is not to say that futures traders haven’t shifted to the options market. The second major reason for the jump in options volumes was the volatility in the markets last year, coupled with the pressure of low liquidity in the markets. While the former resulted in an increase in risk aversion, the latter led to trading strategies, which used capital efficiently. When the markets were on their way up, most traders were happy to use the futures market, where both the upside potential and the downside risk are unlimited. But thanks to the rise in risk aversion last year, an increasing number of traders preferred buying options, since the risk is defined.
Similarly, since the downside is limited to the option premium paid, margin money isn’t locked up, leading to efficient use of capital. These reasons, coupled with the drop in transactions cost, have led to the shift in trading interest to the options market. It’s significant that both these changes happened around the same time last year and have together fuelled the growth of the market.
Of course, for every buyer of options, there has to be a seller or writer. The surge in volumes wouldn’t have been possible unless proprietary desks and volatility traders wrote large numbers of options. True, institutional investors, too, have been writing covered calls, but the Indian market has a disproportionately high level of non-institutional participation. In most developed markets, option writing is the domain of institutional investors.
Policymakers can now take advantage of the expertise in the equity options market, by allowing currency options and interest rate options on the exchange platform. Currently, options are permitted in the over-the-counter segment run by banks, but volumes are much lower compared with forward contracts, indicating that the equity options market is at a far greater level of maturity. Besides, the successful launch of currency futures gives the comfort that India’s large trading community can adapt to new markets quickly.
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