European exercise style fails to enthuse single-stock options

European exercise style fails to enthuse single-stock options

Mumbai: The share of single-stock options in derivatives turnover has steadily declined in recent months, despite a change that was meant to make the instrument more popular with investors.

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In October, the National Stock Exchange (NSE), the primary bourse for trading derivatives, introduced the European exercise style on all stock options expiring in and from January, to bring the instrument on a par with the popular index options.

But index options continue to dominate. Their share in the total derivatives turnover increased to 69.86% as on 23 February from 61.70% six months earlier. Over that period, the contribution of single-stock options declined to 2.95% from 3.96%.

Analysts blame this on the volatility in the cash market, rising premiums and a lack of retail participation.

“We had expected volumes to rise after the change to European style but there are not enough retail participants because of higher premiums and weak market conditions," said Siddarth Bhamre, head of derivatives at Angel Broking Pvt. Ltd. “I would expect volumes to pick up gradually."

Average daily volume in stock options trading dropped from 158,253 contracts in September, when the stock market was rising, to 149,162 so far in February, which has seen about a 5% decline in NSE’s Nifty index.

An NSE spokesperson said it was too early to comment on the matter.

American-style options can be exercised on any day leading to the expiry of the contract. European-style options can be exercised only on the day of the expiry, a method that incentivizes option-writing since the seller of the option knows with certainty when he might be asked to settle a buyer’s claim. Options are derivatives that provide a buyer with the right to bet on the price movement of an asset without placing the buyer under any obligation to transact, in case the bet turns wrong. In return, the seller of the option earns a premium paid by the buyer. Unlike in futures trading, the buyer’s risk is limited to the premium paid.

Options on individual stocks have the smallest share of the derivatives pie in India. Index options are the most popular.

Market regulator Securities and Exchange Board of India on 27 October allowed stock exchanges the flexibility to offer either European-style or American-style stock options.

NSE, which has a near monopoly in the equity derivatives segment, issued a circular the next day introducing European-style contracts on stock options starting from the January series.

Its older rival, Bombay Stock Exchange, which has less than a 1% share in the equity derivatives market, followed suit with a similar circular on 18 January for all stock options starting from the March series.

“It makes sense for retail investors to trade stock options if he has underlying exposure," said Bhavin Desai, manager, derivatives, at Motilal Oswal Financial Services Ltd. “It will take time for the market to mature and liquidity to increase."

Index options also took time to grow, Desai pointed out. Introduced in 2001, a year after futures started trading on Indian exchanges, options trading used to lag futures, which had the major share of the derivatives market till 2008.

Favourable tax treatment and a change in risk appetite of traders who lost money during the stock market crash of 2008 led to a change in the composition of the derivatives market. Volumes traded in single-stock options are higher than in index options in most developed markets. For instance, volumes on single-stock options sold on the Chicago Board Options Exchange was three times the volumes on index options in January, according to data from the World Federation of Exchanges.

The lack of successful lending and borrowing mechanism limits liquidity in stock options in India, said Sandeep Singal, co-head, institutional equities, at Emkay Global Financial Services Ltd.

As asset management companies are barred from selling single-stock options, the market for options on individual stocks is expected to grow only when retail participation picks up. “Foreign institutions would be interested in participating only when they see greater liquidity," said Singal.

Graphic by Yogesh Kumar/Mint