NSE move to bring liquidity to several stock options
The country’s top two equity exchanges, the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE), are changing strategies to attract volumes.
To counter the threat to its dominance in equity derivatives, NSE has decided to pitch European-style stock options against BSE’s move to replace (in December) cash settlement in derivatives with physical settlement. NSE will replace the present American-style stock options with European-style ones from January.
If NSE’s volumes rise due to the move, its liquidity pool will widen, it will be able to retain trader attention and not be vulnerable to losing some derivatives volume to BSE, which is being anticipated after the latter launches physical settlement in derivatives.
“European-style options will generate more volumes for NSE. They will also bring liquidity to several stock options, as they will not be vulnerable to huge gaps up or down on opening prices,” said Siddharth Bhamre, head of equity derivatives at Angel Broking.
NSE’s share in the exchange-traded equity market is over 98 per cent. On an average, Rs 1.5 lakh crore worth of equity derivatives contracts are traded daily on NSE. In fact, the turnover crossed Rs 2.53 lakh crore yesterday. While the share of NSE index options is nearly 50 per cent in this, stock options account for merely three to four per cent, as only 20-30 counters are liquid out of over 200 stocks in the derivatives segment.
Takeoff issue
“European-style stock options usually go well with cash-settled derivatives. They reduce the overnight risk for uncovered sellers of stock options. But it can be termed as just an experiment before it really takes off,” said J R Varma, professor of finance at Indian Institute of Management, Ahmedabad.
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The expiry date of a stock option specifies when the contract will become void. European-style stock options are only exercisable on the expiry date, cutting the overnight risk of volatility in the underlying asset for sellers. American-style stock options are exercisable any time before the expiry date, which is why traders are afraid to take positions on NSE, as volumes show.
Under physical settlement, a seller of stock futures or options has to deliver shares to the counter-party when the contract expires, which will bring down the manipulation prevalent under the cash-settled system. However, if positions are squared off before expiry, only then will there be an option available for cash settlement.
At present, delivery-based volumes are 15 per cent of the daily average in Indian equity markets. With physical settlement, a big crash and subsequent closing of the market can be prevented, as the counter-party to the short-seller in derivatives will have the option of asking for delivery. The new mechanism should also reduce market volatility, as it will not be possible to artificially suppress share prices.
Brokers feel BSE’s idea may work by encouraging stock lending and borrowing, as more people will borrow to give delivery, which in turn will revive financing for borrowing stocks (the old system known as ‘badla’), a highly lucrative business.