The Hindu Business Line : Derivatives: Changing the rules for better participation

The recent market crash has prompted SEBI to consider changing regulations in the derivatives market. This article suggests three measures that can encourage active participation in that market. First is the change to a uniform contract size of 100. Second is imposing circuit breakers on futures and not just on the underlying. And, third, reducing margin requirement on short-legs on spread trades.

B. Venkatesh

Recent media reports indicate that SEBI is likely to change trading regulations in the derivatives segment. This would be quite welcome.

The Indian derivatives market has been starved of a friendly market microstructure for long. Large contract sizes, high margins and low liquidity have pushed many participants away from the market. In this article, we suggest three measures that could be considered to encourage active participation in the derivatives market.

Uniform contract size

At present, the contract size is dependent on the spot price of the underlying as it relates to a fixed value of Rs 2 lakh. So, if Reliance Natural Resources (RNRL), on a specific day a few years ago, was trading at Rs 25, the contract size was fixed at 7,190. If the price moved from Rs 25 to Rs 240, traders had to simply pay a higher margin — that would go up from Rs 80,000 to Rs 3.85 lakh per contract!

The NSE does reduce contract size when the margin rises to very high levels but it is almost always rather late in the day. We believe that the markets should shift to a uniform contract size of 100. There are at least two advantages in doing so. First, it will attract more participation in the market, as derivatives will become more affordable. This will lead to better price efficiency. And second, traders can construct innovative income-enhancing strategies.

A plain-vanilla strategy would be covered call-write. This is a strategy where traders sell a higher strike call against the underlying asset. Another strategy is to take advantage of spot-futures differential. Suppose futures price is Rs 100 while spot trades at Rs 110. A trader can sell the stock that she holds and buy futures. Typically, futures will trade above spot after sometime. That is when the trader can reverse the transaction and take profits.

If a trader wants to take advantage of the price differential between RNRL spot and futures now, she needs to hold 1788 shares of the stock and have enough money to pay margin on the futures! The strategy would be easier if the contract size were 100.

Circuit Breaker

It is likely that SEBI may impose circuit breakers on stocks in the derivatives segment. We believe that circuit breakers should be imposed on futures as well.

Those actively trading in the derivatives segment may have observed the price disconnect between index futures and the spot index. Similar trading behaviour would emerge among all stocks if SEBI were to introduce circuit breaker only on the underlying.

Take RNRL. Suppose SEBI introduces a 20 per cent circuit-breaker on the stock. From Rs 120, suppose RNRL hits the upper circuit on a given day; trading would halt at Rs 144 in the spot market. But futures price could well go to Rs 170!

The classroom traders may immediately point out to the arbitrage opportunities that arise if there is, indeed, such price differential. So, an astute trader would buy the stock and short-sell futures.

The problem is that the futures price will be entirely dependent on the trader who “operates” that contract. So, even if the most astute institutional investor were to short-sell futures, the operator-trader can continue to bid up prices and maintain Rs 30 to Rs 40 differential- till the contract expires.

Such price differential could lead to asymmetric payoffs. That is, the operator-trader will almost always profit while her counterparty will almost always lose trying to take advantage of the arbitrage opportunity. The price disconnect can be moderated if SEBI were to instead impose circuit breaker on futures as well.

Suppose a trader wants to set up a bull call-spread. This involves buying a lower strike call and selling a higher strike call.

Margining short-legs

The NSE will collect margin on the short-leg, even though a short option when combined with a long-leg is not as risky.

Take Nifty 5000 long time-spread. This involves buying March Nifty 5000 call and selling February 5000 call. Any loss on the short February 5000 call will be largely taken care of by the gains on the long March 5000 call. SEBI can, hence, considerably reduce the margin requirement. If the trader were to only close the long-leg, the stock exchange could indicate the higher margin requirement on the open short position.

Reducing margin requirement on the short-legs in spread trades would lead to active trading in the options market. Traders can also then engage in switch trades — setting up covered call-write with futures.

We have covered only a few of the issues that need to be addressed in the derivatives segment. This article just brings to the fore some important issues that need to be addressed soon.

(The author is a Chennai-based investment strategist. He can be reached at enhancek@gmail.com)

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