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Anup Menon

IT IS nine months since exchange-based option trading on individual stocks began in the Indian market. Considering that this is a structural change, it would be interesting to note its impact on the spot market. An analysis suggests that in certain stocks both volatility and returns in the spot market have declined after options trading began. Volumes in the spot market declined in most cases, post listing.

The stocks of six most-actively traded options — Infosys Technologies, Satyam Computer Services, Sterlite Opticals, Reliance Industries, Reliance Petroleum and Digital Globalsoft — were examined; given the nascent stage of the derivatives market, these stocks contribute much of the volumes.

Volatility effect

Regulators and market participants have been interested in observing the impact of the listing of options on the spot market, especially in terms of volatility. For instance, the 1987 crash is widely blamed on the excessive use of financial derivatives. Therefore, a fundamental concern is whether speculation in the option market gives rise to higher volatility in the underlying asset market.

The Business Line analysis showed that the introduction of options had a positive impact on the market as a whole.

For instance, the volatility of the BSE Sensitive Index declined, after introduction of options. It should be noted that index options were also introduced at the same time, though index futures had been in existence for more than a year. To the regulators and the market participants this should be good news as, to some extent, speculation-driven price variability seems to have diminished, at least in the spot market. For instance, in such stocks as Satyam and Infosys there was a reduction in volatility of returns.

However, it was the reverse for stocks such as Reliance Petroleum and Reliance Industries. For the entire sample, the tally was split evenly.

So, can we conclude that speculator interest in actively trade stocks has actually moved to the derivative market? Available evidence is not conclusive.

Because on average the most actively traded options have been on Satyam Computers, Reliance Petroleum and Reliance Industries.

Within this sub-sample, there was reduced volatility in the first one, but a substantial increase for the other two. Hence, it cannot be concluded that the introduction of options lead to a reduction in volatility.

Volume effect

Another concern among empirical researchers has been the effect of introduction of options on volumes. The options market provides an alternative arena for speculators. For instance, assuming that speculators move from the spot to the options markets, there could be a drop in traded volumes in the former, assuming that other demand factors do not change.

The impact of the fall in volumes translates into a drop in liquidity in the spot market, in turn leading to a widening of the bid-ask spread. Therefore, the drop in volumes is not something investors and regulators want. In fact, research in developed markets has shown that the introduction of options has actually led to an increase in the volumes in the underlying asset market.

According to Business Line analysis, in five out of the six cases there has been a drop in volumes post introduction of the options market. Further, if volumes are compared, in absolute terms, the biggest decline has been in Satyam Computers, followed by Reliance Industries and Reliance Petroleum, the three most actively traded options. Therefore, there is nothing to support the theory that the introduction of options has led to a rise in trading interest in the spot market. One possible explanation could be that listing options have actually not led to an increase in hedging demand which would has resulted in increased volumes in the spot market. Rather, the options market seems to be more of a speculators market.

However, this should also be considered in light of the changing market structure. For instance, since July 2001, the settlement system has moved to the rolling format. Hence, speculators have less incentive for trading in the spot market as they may have much better opportunities in the options market. This could have been a major driving factor for the drop in volumes in the spot market. The reasons for the drop in spot volumes could be due to a many factors. But the available evidence clearly suggests that speculators have moved to the options market.

Further, it is also possible that hedging demand in the options market will not be significant.

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