Growth in derivatives trading

Businessworld

Rajesh Gajra

Coincident with the upsurge in stock prices, and notwithstanding the occasional hiccups like the one in August 2007, activity in the derivatives market of futures and options (F&O) has also accelerated considerably. Professional speculators, arbitrageurs, institutional investors and retail investors have all upped the ante by trading in futures and options.

The pace is breathtaking. Going by the numbers, there has been a doubling of trading volume every two years. When the National Stock Exchange’s (NSE) index of 50 stocks, or Nifty as it is more commonly known, moved up by 66 per cent — from a level of 1500 points in October 2003 to 2500 points in October 2005 — the daily traded value in the F&O segment of the NSE increased by 116 per cent, from an average of Rs 10,016 crore to Rs 21,683 crore. Investor excitement, on the back of the global bull run, continued to run unchecked from October 2005 to September 2007, despite the steep correction in stockmarkets worldwide in August 2007.

The Nifty has shot up by 80 per cent to 4500 points. The frenzy in derivatives trading has grown as dramatically, to an average daily traded amount of Rs 53,644 crore in September 2007, a 147 per cent increase from October 2005. “The liquidity in F&O has gone up substantially,” says Sanjiv Shah, executive director of Benchmark Asset Management, which has an arbitrage fund — that trades on differences between futures and spot prices. “You can do size, that is, put in higher order quantities, and yet expect to get a fair price.”

Changing Market Dynamics

Empirical study of the world derivatives market indicates that price discovery first happens in futures — a contract under which investors agree to pay a predetermined price for a stock at a specified future date — and is then reflected in the cash market, rather than the other way round. As a result, trading volumes also tend to rise in the latter. “The FIIs would take, say, Rs 100 crore exposure on a single stock and then would go short on Nifty to knock out the market risk from the stock exposure,” says Shah.

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The cash market’s daily average traded value figure of Rs 15,330 crore in September this year is a 116 per cent increase from October 2005. But the levels reached by derivatives has surpassed the cash market in leaps — since index futures went live in June 2000. The NSE is clearly the frontrunner. BSE’s Sensex futures and other stock derivatives on BSE attract only about 2 per cent of the combined derivatives turnover.

There are other important characteristics in the trading of derivatives in India — for instance, there is a preponderance of stock futures, which contribute a little over half of all derivatives trading volume. No other large equity derivatives exchange compares on this front — in most cases it is usually index futures or index options that dominate trading volumes.

The same speculative and arbitrageur ethos that was displayed in the erstwhile badla mechanism is now manifested in stock futures. It seems traders cannot get enough, dabbling in the all-time favourites, Reliance Industries, other Reliance companies, State Bank of India, Tata Steel, etc., with new flavours such as GMR Infrastructure occasionally creating a ripple. “It’s the leverage that has always attracted the individual risk-taker,” says Gurudatta Dhanokar, head strategist in derivatives at Almondz Global Securities, a broker on the NSE. “He could have an investment of, say, Rs 2 lakh in a fixed-income asset, but would then rather take a Rs 2 lakh exposure in derivatives by paying only 10-30 per cent as margin.”

Coming Of Age — Almost

Stock futures dominate trading on a collective basis. The highest trading, however, continued to be in Nifty futures. More important, once not as liquid, stock and index
options — where the writer of the contract has the right, but not the obligation to buy or sell a specified stock — are now beginning to generate interest. Index options, particularly Nifty options, have seen their share rise steadily from 7 per cent in 2005-06 to 11 per cent in 2006-07. “Liquidity in Nifty options is consistent, irrespective of the direction of the market,” says Dhanokar. “But in American-style stock options (where they can be exercised daily), the liquidity goes for a toss when the market turns bearish and the premiums turn expensive.”

Another significant dynamic that has fuelled the growth of the derivatives market is the participation of FIIs, whose share in F&O trading has gone up from 7.5 per cent to 14.4 per cent in the past two years. Within pre-specified limits, the FIIs are permitted to hedge or even take unhedged exposure through F&O in stocks or indices. But retail interest accounts for 60 per cent of the entire market. Proprietary trading by brokers is the second-largest contributor to F&O trading volumes — 26 per cent in August 2007. But that is down sharply from 41 per cent in August 2004, implying a diversification of participants in the derivatives market.




Liquidity, depth and maturity are visible in the growing proportion of open interest or unhedged positions — as also the bigger risk appetite. A review of the NSE’s monthly statistics shows that the percentage of open interest to daily average traded value was about 109 per cent in June 2006. In other words, the majority of trades were getting squared off every day; not much getting carried forward to the next day. “That meant traders did not want to take overnight risk,” says Dhanokar. But the latest NSE statistics for August 2007 says the open interest proportion was 172 per cent, implying that F&O traders are taking longer calls on the market.

That said, derivatives have been the cause for the failure of venerable institutions such as Barings Bank in 1995, and losses from derivatives trading have blown big holes in balance sheets of global companies. But for hedgers, arbitrageurs, and other risk-takers, the new-found maturity of the Indian derivatives market is a welcome sign.

See: Commodities Trading