The derivatives market will now graduate to adulthood with the advent of the much awaited delivery-based settlement of contracts. The equity derivatives market business volumes have grown at an unprecedented rate in the last decade. Volumes in index futures and options have exploded. However, scrip options have not picked up. The nature of volatility in scrip and an option seller’s inability to price in lower premium could be the reasons for this.
When derivatives contract are settled physically, there will be implications for all players in the derivatives segment — speculators, arbitrageurs and hedgers. The speculators today have all profit and losses settled in cash. Any buyer of a call or put option who wants to take or give delivery, respectively, cannot do so. They have to settle and buy or sell delivery in the cash segment.
Options, as they are meant, should give them a choice to play with the delivery of shares. When physical delivery starts in options, they will be able to do a dip-stick analysis. Similarly, option sellers will benefit by executing 'covered call' or 'protected put', with choice to do a physical delivery. The strategies will be successful and premium will be valued appropriately.
Arbitrageurs will have to deal with the challenges of a physical delivery. They will have to extensively use lending and borrowing from the stock lending and borrowing platform to settle trades. Arbitrageurs will be needed to take the lead in developing this segment of the market. The price discovery process will become more efficient by their participation with physical delivery of assets.
Many fund managers do not hedge today due to the absence of physical settlement in the segment, exposing the fund to market risks during turbulent times. Hedgers will see the benefit of hedge. They will be able settle their hedge positions by physical delivery. Their active participation will create a vibrant market and better premium pricing in the scrip options.
Margins from exchange will also be well managed. As on date, margins on covered call and protected put are collected in full, which can be significantly lowered or made nil by the exchanges when delivery-backed assets or contra strategies are inter-linked. At nil or nominal margins, the trades in scrip options are set to explode.
With a physical delivery in the derivatives segment, a new beginning for a diverse range of products and strategies in the market will be created to benefit all players for managing risk and creating wealth.
The author is Senior Vice-President (Business Associate Group), Motilal Oswal Financial Services
