Now we have options

It was roughly six years ago, in June 1995, that efforts towards starting derivatives trading in India began in earnest at the NSE. After five years of effort, index futures started trading in India in June 2000. Now, in June 2001, options trading has commenced.

What has been going on with the index futures? Three exchanges compete in the index futures market: NSE, SGX and BSE. There have been days on which SGX or BSE have done the most trading volume. However, in recent months, NSE has had roughly 90% market share.

The highest-ever trading volume, seen on 23 February 2001, was Rs.71 crore. Turnover dropped sharply in March, April and May, and has seen a revival in June, where the typical value for daily trading volume on the index futures has proved to be roughly Rs.20 crore. For all practical purposes, there are roughly 50 NSE member firms which are active in the market; i.e. most NSE firms have yet to get their act together.

Of the three index futures products which trade, the near contract has become fairly liquid. Trading in small lots on the June contract takes place continuously through the day. The bid offer spread ranges from Rs.1 to Rs.3 (i.e. 9 to 27 basis points), which makes it quite liquid when compared with the most liquid stocks in the country.

Why are options interesting? Options are a profoundly new stage for the development of India's financial system. Options are the first "nonlinear" financial products to feature in India. On expiration date, a Nifty call with strike price of 1200 is worth Rs.10 if Nifty is at 1210, but is worth 0 if Nifty is below 1200. This nonlinearity implies that a whole host of interesting new trading strategies are possible, for the first time, using options.

At the same time, the nonlinearity of options implies a whole new level of analytical complexity. The price of options depends on forecasts of volatility. For the first time, traders in India are now taking interest in forecasting and speculating on future volatility as opposed to only having views about future fluctuations of the price.

Hedging away futures exposures is simple and straightforward. In contrast, hedging options requires "dynamic hedging", where the hedge is repeatedly adjusted as prices and volatilities change.

These analytical demands will generate a valuable new pressure for the growth of skills in India's financial system, and reward individuals and firms which are good at attracting and cultivating knowledge.

Using options: hedging. Buying a put option is like buying insurance. A Nifty put option with strike 1100 is worthless until Nifty hits 1100; but if Nifty drops below 1100, the investor is fully reimbursed for the price drop. Hence, buying a put option at 1100 is like buying insurance which pays in the event that Nifty ends up below 1100. The price paid for the option is the (non-reimbursable) insurance premium, this money is a cost incurred whether or not Nifty ends up below 1100.

Every portfolio in India is vulnerable to fluctuations in Nifty. For the first time now, investors can choose to buy insurance and protect themselves against this risk. This is a new environment for equity investment in the country. Traditionally, there was only one choice: to own equities (and suffer the risk) or to not own equity. Now there is a third path: to own equities, and to buy insurance which takes care of unpleasant extreme events. Each investor can make up his own mind on what kind of hedging is desirable: a more cautious investor may find it worth paying a higher fee for protection that sets in when Nifty drops below 1100, while an investor with greater risk tolerance can choose to spend less on protection which only sets in below 1000.

Using options: speculation. Options are extremely convenient tools for speculation. A person who believes that Nifty will rise buys call options, a person who believes that Nifty will fall buys put options. In either case, the price of the option is paid up in full immediately, and this price is non-reimbursable. If Nifty moves in the correct direction, the position captures the full upside. If Nifty does not behave correctly, the speculator suffers no further loss. The position can be squared off for immediate profits, or held until expiration and exercise.

The key feature which makes options convenient is that there is no possibility of bad news generating fresh losses. A speculator using the futures gets into the futures position "for free", but he has a two-way exposure. If Nifty goes up, the futures buyer gets the profit but if Nifty goes down, he suffers that full loss. Large price drops in Nifty generate large losses for the futures buyer. In contrast, speculation using options is safe and contained. The speculator buys the option, pays for it in full, and then sleeps in peace. At worst, the option will prove to be worthless, but at best it can yield huge profits.

Market making. If a certain derivative product is seen to have wide bid/offer quotes, then traders have an incentive to come in with two--way quotes, and earn the spread on round--trip transactions. If someone buys a June 1120 call from you at Rs.20, and then someone sells it back to you for Rs.18, you have a profit of Rs.2. While doing such "market making", the trader has to temporarily hold inventory in the form of a position which is either positive or negative. This risk should be hedged away, using the most favourable alternative.

The most liquid raw material that's available for hedging, today, is the near month futures. Traders can supply liquidity on the far month futures, and hedge themselves by placing market orders on the near month futures. Similarly, traders can supply liquidity on any of the traded options, and hedge themselves by taking offsetting positions on the near month futures, using a technique called "delta hedging". For all these efforts, the near month futures is shaping up to be the crucial, liquid, raw material through which other positions can be hedged.

The new frontier - arbitrage. A major weak link in India's financial sector today is knowledge and financial capital deployed behind arbitrage with futures and options. The months of March, April and May were an embarassing public display of ignorance, as the Nifty futures suffered huge mispricings which was riskless money on the table for any institutional investor which had the minimal skills required to pick it up. The finance professionials of the country displayed shocking gaps in knowledge in the fact that these mispricings were not exploited till early June. There is something truly worrisome about an educational system which is producing finance professionals who have such limited knowledge of finance.

Now, with options, we will see fresh demands on knowledge about pricing and arbitrage on the part of finance professionals. It will be interesting to see whether they are able to rise to this challenge.

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