Will reduction in F&O contract size cut volatility?

Investors having positions in the cash segment use the derivatives markets to hedge their positions to counter volatility or loss in value to their underlying.

The Indian equity markets, though, have witnessed extreme volatility in the last few weeks with the derivatives market seeing big action as players are using the futures & options (F&O) markets largely for speculation and arbitrage between the F&O and cash markets. In fact, turnover on the F&O segments has been consistently on the rise.

Players have taken big positions by paying small margins in the F&O segment as they can take a position on a larger quantity of the stock for the same money they would have to put in if they were buying in the cash market.

But this leveraging has to an extent been limited to larger players as the contract sizes are too big, making margins payable slightly out of reach for smaller players.

To counter this and make the hedging tool available to all, Securities and Exchange Board of India (Sebi) has proposed to cut down the contract size from the current Rs 2 lakh to Rs 1 lakh.

One of the remedy to reduce choppiness in the market is a reduction in contracts size, which in turn increases the number of participants and thereby generate greater volumes.

Ajit Surana, managing director, Dimensional Securities, said, "Of course, reduction in contract side will see more retail investors entering the markets as lower contract size means lower margins and reduction in risk."

Mukul Pal, analyst at Edlwless Capital, said, "A reduction in contract size will surely improve tradability, as the margins paid will not be astronomical. But I don't think that volumes are going to increase dramatically. Moreover, increasing tradability may or may not increase volatility, as volatility is more owing to market view and exposure than because of just high volumes."

A derivatives analyst at an institutional brokerage house adds, "Currently, the contract values are so high it is difficult for even many high net worth investors entering the derivative market. A reduction in contract size will definitely stablise the market as the trading interest will be more wide spread."

Adds Arindam Ghosh, country head, First India AMC, "Retail participation in the derivative markets will take time... but definitely widen the market interest gradually."

The sharp choppiness in the markets is also attributed to continued skew in trading interest in near-term contracts witnessing hectic actions, indicating absence of real hedger in the market.

According to Mukul Pal, hedging is a horizon and even if the current month is active, hedgers can always keep rolling their exposure to the next month. So, localised trading in just the near month does not hinder a hedger or convert him into a speculator.

But does this also mean that people do not have a long-term view? No it does not mean that, it only means since views keep changing with additional information coming in, operators have the right to change their positions.