Though turnover in the overall options segment of the F&O market continued to surge in 2010, the turnover in stock options remained low due to abysmal liquidity in the stock options segment.
Only 10-15 stocks in the stock options segment?out of 223 securities traded on the F&O market?are liquid, market participants said. In fact, the top 10 stocks in this segment contribute to as much as 60% of the turnover. Reliance Industries, Tata Motors, Tata Steel, SBI, ICICI Bank, IFCI, Hindalco Industries, Unitech and Infosys are among the most liquid stocks.
The liquidity in the options segment is a function of the option writers? willingness to enter the market. Option writers face unlimited loss as opposed to option buyers for whom the loss is limited to the premium paid. This risk is exacerbated in the stock options segment because of the volatility of individual stocks against index.
?Sellers carry the risk of assignment. If this risk is taken care of, options writers will come in,? Angel Broking head?derivatives Siddarth Bhamre said. Assignment risk is the risk that an option writer has to take if the option is in-the-money as an option writer never knows when he’ll be asked to fulfill the contractual obligation.
Option writers face a greater risk in American-style options as the option can be exercised on any day before expiry of the contract which in turn increases the potential of a huge loss for the option writer.
That is why derivative analysts feel that the proposed move by market regulator Securities and Exchange Board of India (Sebi) to allow stock exchanges the flexibility to offer either European-style or American-style contracts will help improve liquidity in stock options. Currently, only American-style contracts are allowed in stock options.
?The European style of settlement should bring in more option writers as they don’t have to worry about untimely exercising,” Prabhudas Lilladher institutional derivative analyst Savio Shetty said. European-style options can be squared off only on the day of expiry or maturity.
Inclusion of highly liquid stocks in the F&O market could also help bring in options writers in the stock options segment. ?Stocks with lesser free float and low liquidity should not be included in the F&O segment. It is better to have 100 stocks with high liquidity rather than 300 stocks with low liquidity,? Bhamre said. However, Shetty believes that ?as long as the stock is liquid there is no problem in including more stocks?.
Sebi?s move to introduce physical settlement could also impact liquidity. While this practice might add more stability to the market (as the options writers will have to have stock in hand), it is not a good idea to introduce it right now as options writers will turn more cautious, feel market observers. ?Ideally, the market regulator should experiment with European-style options for some time before introducing physical settlement,? Shetty said. Also, the regulator will have to strengthen the SLB (stock lending and borrowing) mechanism to ensure smooth functioning of the physical settlement, he adds.
Shetty believes that we could follow the practice followed in the US, where it is left to option buyer to decide between cash and physical settlement.