Sucheta Dalal :Five-year index options: A viable option?
Sucheta Dalal

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Five-year index options: A viable option?  

May 5, 2010

Buoyed by the rising share of index-based options in total derivatives volumes in the past few years, capital markets regulator Securities and Exchange Board of India (SEBI) has allowed exchanges to offer options contracts with tenure up to five years.

However, it will be a difficult task for the stock exchanges to attract enough liquidity on a sustained basis in this segment. Currently, contracts that are even two months away, form only a small portion of the derivatives markets. Shorter duration contracts attract a lion’s share (90%) of the total trades on the National Stock Exchange (NSE).

Monal Desai, VP & head-Institutional Equities (Derivatives), Prabhudas Lilladher Pvt Ltd, does not believe that long-dated options are of any value. “I don’t see how this move will work out given that liquidity is already quite low currently. Besides, not many investors would want to take a call over the five-year period. Long-dated contracts have a very minuscule part to play in the overall market. I hardly anticipate any growth in volumes as a result of this move,” he said.

Indeed, there is hardly any trading in this space as the contract expiry grows longer. At the strike price of Rs5,100 (the Nifty’s current level), there were 213,878 transactions on Wednesday for the contract expiring on 27 May 2010. For the 24 June 2010 contract, the volume was just 7,285 contracts. For the September series, there was no volume at all. If this is the situation over near-term contracts, there is no scope for having any amount of liquidity over a five-year period.

Since liquidity is low, the bid-ask spread is so wide, it is difficult to see how one can expect to attract liquidity at such prices. For instance, for the 30 December 2010 contract, the bid-ask spread is Rs325-Rs537. For the contract expiring in 27 June 2013, it runs up to Rs1,213-Rs2,000. The situation is so abysmal that there is not even any open interest at this level.

Not only is there not any trading in long-dated options, it would also create some administrative difficulties while managing the settlement of these contracts, which will be offered on a three-monthly and quarterly basis, besides eight semi-annual contracts being offered with June or December expiry.

Earlier in March this year, the proposal of the derivatives market committee of SEBI to introduce longer-term options contracts was approved by the SEBI board. The committee had suggested in its report, “The growth in turnover of long-dated options is greater than that of short-dated options. With the market having gained sufficient experience in longer tenure options, it is recommended that options with tenures of up to five years may be considered for introduction.”

An option is a contract between two parties wherein the buyer receives a privilege for which he pays a fee (premium) and the seller accepts an obligation for which he receives a fee. An option gives a person the right but not the obligation to buy or sell something.

In January 2008, SEBI had allowed stock exchanges to offer options contracts with tenure up to three years. SEBI has stipulated certain conditions before the exchanges could launch such contracts. It has mandated that there should be eight semi-annual contracts maturing in June or December. In addition, three monthly and quarterly contracts that expire in March, June, September or December must also be offered. SEBI has also stipulated that the exchanges put in place the appropriate risk management framework for such derivative contracts. — Sanket Dhanorkar

-- Sucheta Dalal