Options trading -- Include riskier stocks too

B. Venkatesh

Anup Menon

THE Securities and Exchange Board of India (SEBI) says there should be no `option' contracts in stocks with a high degree of volatility.

Among the four criteria SEBI has framed for selecting stocks for `options' trading, one is volatility. Stocks are eligible for option trading only if their volatility in the past six months is less than four times the volatility of the market index.

But such risky stocks are the ones investors would like to `option-trade' in. After all, it is through such `options' trading that an investor limits his losses. By buying options in stocks such as Global Telesystems and Himachal Futuristic, arguably some of the most volatile in the market, one can hedge one's position in the underlying stocks.

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The stocks in which SEBI now allows `options' trading number 31. But this excludes several stocks that are part of the National Stock Exchange's index of 50 pivotal stocks -- S&P CNX Nifty. It also excludes a number of stocks which consistently figure among the top turnover stocks.

Our argument is that option trading should also be introduced on stocks with higher volatility, or are more risky. We selected 60 stocks drawn primarily on these two criteria. The selection was based on their volatility levels and investor interest in the spot market. Of the 60 stocks analysed, 50 form part of the S&P CNX Nifty, while 10 are non-index constituents, though heavily traded.

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The analysis shows that:

*Of the top 25 stocks ranked on volatility, options were introduced only in 15.

*Major stocks that do not figure in the list include Himachal Futuristic, DSQ Software, Global Tele Systems, SSI, Silverline Technologies, Wipro and Zee Telefilms.

*Most of the stocks introduced for option trading have an average monthly volatility of 6.42 per cent. Market players translate this into a potential yearly volatility of as much as 20 per cent.

*Certain heavily traded stocks on which options have not been introduced have an average monthly volatility of 7.68 per cent, which translates into a scaled yearly volatility of 24 per cent.

The findings, thus, show that the SEBI rule on volatility is inconsistent with the fundamental characteristic of option trading. Why? As options are primarily bets on volatility, there is more reason to introduce them on highly volatile stocks than less risky ones.

If volatile stocks have options traded on them, it will help hedgers better manage their risk. Besides, speculators can take option positions in risky stocks, thereby, imparting liquidity in the options market.

Hedging risks

The question of hedging primarily arises for investors with long-term horizons, but who are also concerned with protecting the downside in the short term. Mutual funds typically fall in this category.

Take any technology fund. The top holdings in such funds, typically, consist of high volatility stocks, such as Himachal Futuristic, Global Telesystems and Wipro. Suppose the NAV of the fund is Rs 100. A 20 per cent drop in these stocks due to a bearish market will bring the NAV down to around Rs 80. Since a fund's performance is gauged by its NAV, a drop in its value may mean poor portfolio management strategy. This may cause a run on the fund, as happened in the case of UTI's US-64 scheme.

A fund manager will, therefore, want to protect the downside in NAV by hedging the portfolio with single-stock options. This way, the fund manager can hedge certain stocks in the portfolio that he thinks could contribute to the short-term downside in NAV. Of course, if the stock price does not fall, the options will be worthless and mutual fund will suffer losses to the extent of the option premium. But that is the cost a fund manager may be willing to take to protect the downside in the NAV.

Now, the SEBI rule on volatility prevents fund mangers from using options to hedge risky stocks in their portfolio. But why should SEBI at all consider the interest of the hedger? The reason is that providing options on risky stocks may improve NAV performance and protect investor wealth, which may have a positive impact on investor sentiment. This, in turn, may lead to more retail money moving into mutual funds. And that, over the long run, may help institutionalise the equity market.

Speculator

Options are just as useful for a speculator as for a hedger. Consider a speculator who wants to bet on the price movements of Zee Telefilms. The average daily volatility in Zee is 5 per cent, 3 percentage points higher than the market index.

A higher volatility leads to higher option value for buyers of call and put options. This is because higher volatility increases the likelihood of the option expiring in-the-money (see Simple Economics, Business Line, July 8).

Suppose the strike price of Global Tele is Rs 190, its current spot price is Rs 175 and the spot price volatility is 3 per cent against the index volatility of 1.24 per cent. There is a strong possibility of Global Tele's spot price moving towards the strike price because of its higher volatility. This means there is a strong likelihood of the speculator buying the option to make more money.

Now, consider a speculator who is short the option (option writer). If the option has more value for the buyer, it means that the risk is higher for the option writer. The reason is that the likelihood of exercising the option is high in such cases. Naturally, the option writer will demand a higher premium to compensate for the higher risk. The option writer, thus, earns more money on more volatile stocks than on the less volatile ones.

Now, the question is: Why should SEBI help speculators earn money? The reason is that speculators provide liquidity to the option market. In most cases, they are option writers, thus providing a market for hedgers. As options on volatile stocks enhance income in the form of higher option premiums, more speculators are likely to be lured to the options market, thus, improving its liquidity.

Finally, consider the secondary effect of introducing options on volatile stocks. A liquid options market may prompt speculators to shift to that market instead of betting on the stock in the spot market. This shifting of trades may temper volatility of the stock in the spot market. Besides, a liquid options market may help in the price discovery process of the stock in the spot market. This point is discussed in detail in the accompanying article, where a case is made for options on illiquid stocks.

Summing up

Our suggestion is that options should also be introduced in highly volatile stocks. This allows investors to hedge their portfolio against likely downside, while enabling speculators to enhance their income from writing options. The presence of these two players drives the options market and provides for better liquidity.