Options market headed for a noteworthy change

The F&O segment has seen the adoption of new lot sizes. That has interesting implications for equity and derivatives markets since it affects liquidity. The move was long overdue with lots earlier set to a minimum round-off of Rs 2 lakh with margins set accordingly. The new lot sizes are set to a round-off of Rs 5 lakh. In most cases, this will mean that lot sizes increase and margins go up accordingly. But it drops in some cases.

In some stocks like Unitech (the multiplier is 7x since the new lot is 77,000 shares, while the old lot was 11,000), Adani Enterprise (12x) and JP Associates (6x), the lot sizes rise by big multiples. In these cases, margins will spike up. In other stocks, such as Eicher Motors, the new lot is 25 shares and the old lot was 125, and similarly in Bosch. So, the lot size drops and margins dip as well.

In a general way, stock futures are actively traded in many stocks and index futures are very liquid. Index options on the Nifty, and the BankNifty are also very liquid and actively traded. Stock options tend to be very actively traded only in a few highly traded stocks and that too, only close to the announcement of results.

Trading stock futures contracts involves putting up around 20 per cent margin, while index futures contracts are generally available at around 14 per cent margin. Buying an option involves paying the premium upfront - perhaps a maximum of 1.5-2 per cent of the value. Selling an option involves putting up the same margin, as the futures contract with premium being received.

The new contracts had already been launched of course, in September, when the November contracts first became available. The rollover last week saw good volume with open interest migrating to November series.

A simple rule of thumb would be to expect liquidity to increase in the contracts where lot sizes (and hence, margins) have reduced. India is a completely cash-settled derivatives market so an illiquid, closely held underlying will not prevent the derivatives contracts being actively traded. If liquidity increases a lot in the stock futures and stock options contracts, we might even see an increase in the trading of illiquid underlyings in stocks like Bosch.

But roughly 100 or so stock futures contracts have seen margins doubled, or tripled, or even more. There could well be a negative impact in volumes of those contracts. Many retail investors would be daunted by the new multipliers.

Bigger lot sizes could also lead to an increased demand for options because that involves less upfront commitment. Buying an option involves paying premium and that is the maximum the buyer can lose. But an option seller can in theory, see unlimited losses.

It is very possible that a lot of retail traders will shift from playing the futures market to become option buyers but they will be less enthusiastic about selling options. If there is such a shift in retail preference, this will create a demand for option sellers, and entities with deeper pockets will certainly be interested in selling options. There will probably be a skew in terms of suppliers, since the number of option sellers will stay more or less the same, versus demand, since the number of option buyers will increase. That should mean higher premiums.

November is also Diwali month. Retail players tend to reduce commitments around diwali and immediately after. FIIs tend to reduce exposures in December. We may see shifts in supply-demand and other effects caused by the new lot sizes playing out to full degree only in January 2016.

The author is a technical and equity analyst