The Hindu Business Line : Does the derivatives alarm ring before the market crashes?

It does not seem to, if the pattern of derivatives trading prior to the last three major corrections in the Indian equity market is any indication. Between May-June 2006 and now, there have been three instances of the market falling — around 5-6 per cent each occasion. And on all the occasions, the trading pattern in equity derivatives immediately preceding the fall, did not deviate from that over a longer period.

There was, therefore, no special signal from the derivatives segment about the impending correction in the cash market. For a market whose trading volumes have far outstripped that of the cash market consistently and for a market that is also expanding to cover a larger part of the underlying universe of stocks, this does not appear to be a good sign.

Derivatives and efficiency

It is sometimes stated that the derivatives market provides the cutting edge of informational efficiency. It assimilates and acts on information more quickly and thoroughly and disseminates it to the underlying cash markets, thereby contributing to more efficient price formation. This argument applies more forcefully in the exchange-traded markets than in the OTC markets given the public and open nature of exchange-driven trading.

A study of the NSE’s derivatives trading statistics — within the limitations imposed by the information available in the public domain — shows, however, that there is yet some distance to be traversed by the Indian market in this regard.

To be sure, this inability of the derivatives segment to throw hints on impending price developments in the cash market has little to do with the structural characteristics of the products themselves — futures and options.

It probably has a lot to do with the way these instruments have been handled and adopted by the users — mainly as speculative vehicles (possibly of the long variety). While derivatives provide a good platform to engage in speculation (which may not be feasible through the cash market), they can also provide good hedging solutions. The hedging capabilities of derivatives do not seem to have been emphasised adequately by the overall market — intermediaries, exchanges, the regulator and the investor community.

Structural limitations

The absence of information about the break-up of the open interest — into longs and shorts and by participant category — on futures contracts is a key structural limitation in the derivatives data being made available by the NSE.

This limitation is all the more serious since futures trading (and single-stock futures at that) dominates the overall activity in this segment.

While the open interest for the market represents a certain number of longs matched by an equal number of shorts, the break-up of this open interest by participant category would be highly pertinent information. In any market, a broad categorisation of the participants as speculators/hedgers is possible and the nature of the outstanding positions of such speculators/hedgers would naturally throw up good hints about their overall market outlook.

In the absence of this information, what will be the quality of the inference from just the level of open interest in the market? It possibly can only show that liquidity is assured in those contracts in which open interest is high.

While the assurance of liquidity is quite important for derivatives market participants, it would be more significant and critical to extract some information (from the open interest) which would be relevant for the entire market. It may be appropriate here to mention the monthly Commitment of Traders report put out by the Commodity Futures Trading Commission in the US – this report gives a break-up of the open interest into longs and shorts by contract/commodity and by participant category. From this, one can have a broad idea of the level of net speculative/hedging positions in the market.

Signals from options

Options, by their very nature, are slightly better than futures in providing signals about market participants’ price outlook. A put option position can, with some qualification, be taken as indicative of a desire to hedge against a price decline.

And a call option position can, again with some qualification, be taken as indicative of higher price expectations. But here, again, a break-up of the open interest on options into longs and shorts would be more illuminative on the overall market outlook and positioning of market participants.

In the absence of signals from futures positions, a study of the options volumes in the past year – just prior to the three instances of market corrections – shows that the option market did not provide any special signals about the outlook for the overall market.

As the Table shows, both prior to the February 2007 market fall and the latest market fall, put options trading volumes were broadly between 1.10 and 1.40 times the trading volumes in calls in the nearest month (maturing) option contracts on the Nifty. The ratio of put to call volumes, over a longer time period, has been approximately in the same range. Therefore, nothing special was happening in the options market that could have signalled the immediate price outlook for the cash market.

Put volumes have been always higher than call volumes and that probably indicates the higher level of (institutional) portfolio hedging taking place through the options market.

If that was the case with respect to the two market downturns in 2007, the put/call volume ratios during/prior to the June 2006 correction were below 1, suggesting that the market was totally unprepared (even more unprepared than in the latter instances in 2007) for the subsequent fall.

On a net basis, more call options were being bought than put options. If one goes by the basic explanation given above — of a call position indicating higher price expectations — it would appear that the derivatives market was caught on the wrong foot, quite badly.

Broader message

Overall, it appears that a lot needs to be done in the areas of information generation/dissemination, creating awareness about product/ instrument capabilities, so that derivatives can play a stronger role in moving towards more efficient markets.

More Stories on : Derivatives Markets | Stock Markets

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Challenging first quarter, managed well

KPR Mills — IPO: Avoid

Take Solutions — IPO: Invest at cut-off

Index Outlook

Does the derivatives alarm ring before the market crashes?