Exciting times ahead for investors in the exchange traded derivatives market

The market for derivatives seems headed for more exciting times. Whether to make or lose a fortune would depend on the individual investor though.

Recent circulars issued by the Securities and Exchange Board of India (see table) show that proposals for derivative contracts on volatility index, index options with five-year tenure, physical settlement in stock derivatives and options on dollar-INR spot rates are on the anvil.

One can naturally expect other moves to follow, such as options in other currency pairs, greater variety in interest rate derivatives, exchange traded options on swaps, etc. That Sebi is still cautious and sceptical about the common investor entering the market is seen from the way the lot size rationalisation is handled. Internationally, all equity derivative lot sizes are for 100 shares.

That means one needs to keep looking up the lot size for every derivative. It has only introduced price range and standard lot size within that price range.

While Sebi has moved the matter forward by intimating that it is ready to approve products once they are designed and placed before it, the exchanges apparently are taking their own time to structure, design and launch them.

The introduction of these products will throw up new opportunities of structuring a portfolio and managing portfolio returns.

Volatility plays an important role in the pricing of an option. The equity market trades European option on the index and American options on individual stocks. An investor going long a stock is bullish on its future prospects. He can either buy the stock or buy a call on the stock. His bullish expectations may be driven by fundamental improvement in the operations of the company resulting in better profitability or due to higher volatility. An investor with a view on volatility would prefer to use the options market to benefit from the changing volatility.

Even at the same spot price, changing volatility perception will make the price of the option move by a factor determined by its vega (a measure of sensitivity of the option price to changes in volatility, other things remaining same). For instance, consider an option in the shares of the State Bank of India. At the current spot price of RS3,137, an option at a strike of Rs3,170 for November 25, 2010 maturity should trade at a call premium of Rs182.83 given the current volatility of 35%. The vega for this option is 506.07. This indicates that at the same spot price, a change in volatility by one percentage point would change the option price approximately by Rs5.06. As the option moves closer to its maturity, its vega will become lower. When the number of days
to maturity changes from 60 days to 30 days, the vega changes from 506.07 to 358.79. As the option moves deeper in the money, its vega moves lower.

Since perception about the future cannot be certain, a player in the volatility game would like to have some hedge against his
expectations going wrong. Options on volatility index could be used by him to hedge against the same. Since the index would be based on the volatility of a basket of shares, there will be basis risk for his hedge and hence it will be necessary for him for determine his hedge ratio carefully and monitor the same over the life of the option, till he exits from the position. If he or she decides to just bet on the volatility of the market per se instead of volatility in the prices of any particular share, the options on volatility index is ideally suited.

Thus, a new opportunity to beneficially play on the volatility expectations would emerge with this product. Without this product also one can play the volatility market by creating a portfolio which is delta/gamma neutral. That is more complicated and not suited for ordinary investor. With this product, for the first time, lay investors can also bet on the volatility going up or down.  The index option with a tenure of five years is another interesting product allowing one to take a long-term view on the stock market at reasonable prices. Option prices being a fraction of the underlying spot price, enables one to take a position based on a view of the market at a much lower cost. If you hold a view that the Indian economy is bound to perform well in the coming years and the index will cross the levels of 22000 to 23000 in 3-4 years, a long dated index option would be the most ideal product to use.

You need not worry about temporary gyrations in the market, your investment is a small percentage of the exposure and as the economy start to growing the index will play out well over time, giving you the profit you envisaged.

You may also want to add to your position at lower index levels to improve your overall profitability.

I emphasise the long-term view since the market may not be very liquid and exiting your position may not be easy. As you move closer to the maturity, the volumes would gather and you may benefit from the higher liquidity as well. One can take a long-term view of the market without betting on any single share or group of shares going up.

Coming to the next initiative of physical delivery, all derivative contracts in equities are cash-settled. The exchange determined price minus your futures price would be your profit or loss. If you use the futures to simply take a position in the stock it should not make much of a difference. However, if you are an arbitrageur holding the underlying and selling the futures, the lack of delivery impacts you in more than one way. For one, when you close out the futures position, you also need to sell the underlying and there could be an impact from basis. Even on the maturity day, there could be a difference. Further, you buy the underlying paying a brokerage and sell the same paying another brokerage. You do the same with the futures.

Instead, if the regulations permit that you deliver the shares against your futures position and broker can only charge a nominal fee for taking your delivery and giving it in the exchange you can save two brokerages one on selling the underlying and another on squaring the futures position. With such a facility, more players would like to arbitrage when prices move out of sync with the fundamentals. Thus futures prices would be in alignment with fundamentals.

Corporates can also use the facility to park excess funds since it will be all risk-covered positions. If they have surplus funds for 30 days or less, they can scan the market to determine the futures margin in various shares. They can drill down to the one with largest margin and buy the shares and simultaneously sell the futures. They will do this to the extent of liquidity in that stock and move to the next best option and so on. On maturity, they simply deliver all the shares and collect the futures price.

It also enables those with a need for temporary liquidity to sell the underlying shares and buy them back in the futures market and get delivery. It works exactly like a repo trade with the exchange guarantee of performance thrown in.

A lot depends on how margins will be structured. Ideally, if the seller of the futures delivers the underlying shares to the exchange on day one, no margin should be levied on his position, since he is standing ready to fulfil his part of the contract. Whether the exchanges would do so or not is a question to be answered by their product structure when they are announced.

Options in currencies are another product that improves ability to play the currency market. For instance, one of my views on euro came out incorrectly in the recent past and consequently I did lose out on the futures contract. If options were available, one would have restricted the loss to the option premium rather than risk a much higher loss in a futures contract.

When you are trading futures and options in currencies, you could also use synthetics to achieve your objectives. For instance, buying a call and selling a put is like entering into a forward contract. One could use synthetics if they offer better pricing than the plain contract. In a fair market such opportunities are not always available but there are small windows of opportunities which can be exploited.

How market participants will put these products to use, and to what advantage, will depend on the product structure and margin requirements. We also need to know how spread margins would be levied. As of now, exchanges have not rushed to take advantage of the circulars and introduce new products. When they do, it will be exciting times for investors and portfolio managers. Who will gain, who will lose, only the future will tell.