China options debut gives traders tool to hedge volatile stocks

[BEIJING] China will start trading equity-linked options for the first time on Monday, giving investors a new tool to manage risk in the world's most-volatile major stock market.

Contracts on the China 50 ETF, an exchange-traded fund tracking some of the country's biggest companies, will begin changing hands on the Shanghai Stock Exchange as part of a trial that Haitong Futures Co. predicts will eventually expand to options on equity indexes and single stocks. It's the first new equity derivative allowed by Chinese regulators since the 2010 introduction of index futures, a market that has grown about 10- fold in the past four years.

China's options debut, which comes 13 years after the derivatives started in India, is part of the nation's effort to lure more sophisticated investors to a market where individuals account for about 80 per cent of equity trading and price swings are the biggest among the world's 15 biggest bourses. The contracts will make it easier for institutions in the US$5 trillion stock market to manage volatility after the Shanghai Composite Index turned into this year's worst-performing equity gauge from the best performer in 2014.

"Launching its first option is a big step for China," said Winner Lee, an Asia equity-derivatives strategist at BNP Paribas SA in Hong Kong. "We can see Chinese leaders' ambition to internationalize mainland shares and gradually build its derivatives market." Structural Changes China's introduction of options follows a string of changes to the nation's stock market structure over the past five years. Aside from index futures, policy makers have introduced short selling, margin trading and a program for international investors to buy local securities using yuan raised overseas. The Shanghai bourse gave foreigners unprecedented access to yuan-denominated shares in November with the start of the Hong Kong exchange link.

"The focus is on attracting large institutional investors," said Freddy Lim, the global head of derivatives strategy at Nomura Holdings Inc in Singapore. "To get to the next phase with single stock options, the bell-weathers such as China 50 ETF options must first develop reasonable depth." If Chinese authorities do decide to expand the options market, it has the potential to become the largest in Asia, said Eric Ren, a Shanghai-based general manager at Haitong Futures, one of the 10 brokerages granted a license to take part in the trial of ETF options. It may take as many as six months for trading in the contracts to increase, with average daily turnover climbing to as much as US$150 million, versus about US$400 million for the underlying ETF, BNP's Lee said.

The HSI Volatility Index of Hong Kong-listed shares fell 4 per cent last week to 15.01, the lowest level since Nov 28. The Chicago Board Options Exchange Volatility Index, known as the VIX index, declined 18 per cent to 17.29.

Chinese authorities are taking steps to avoid a repeat of past experiments in derivatives that led to investor losses and allegations of market manipulation.

Options trading will be limited to institutions and individuals with at least 500,000 yuan (US$80,069) in their accounts, who must pass three tests on their options knowledge before becoming eligible to trade. Individual investors can hold no more than 50 option contracts, according to the exchange.

Policy makers suspended trading of government bond futures for 18 years after a probe into alleged market manipulation, with the market resuming in September 2013. The exchange halted trading of warrants - contracts similar to call options that are issued by companies instead of an exchange - at least 16 times from 2005 to 2008 and started more than 200 probes into unusual trading.

China's ETF options will start with four expiry dates, in March, April, June and September, according to the Shanghai exchange. While the contracts won't be available to foreigners through the Hong Kong bourse link at the outset, Hong Kong Exchanges & Clearing Ltd. has said the connect could be expanded to include derivatives.

The ETF's biggest holdings include Ping An Insurance (Group) Co., Kweichow Moutai Co. and China Minsheng Banking Corp. The fund fell 3.2 percent last week, bringing its retreat this year to 10 percent.

The Shanghai Composite has slipped 4.9 percent since the end of December, after a 53 percent rally in 2014. The gauge's 60-day historical volatility increased to a five-year high on Friday and is four times higher than that of America's Standard & Poor's 500 Index.

Large-Cap Boost Demand for shares held by the underlying ETF is likely to increase with the addition of options, boosting valuations relative to smaller companies excluded from the fund, according to HSBC Jintrust Fund Management Co. The ETF's underlying SSE 50 index trades at 10.7 times reported earnings, versus a multiple of 66 for China's small-cap ChiNext index, according to data compiled by Bloomberg.

"As large-cap financial stocks have a big weighting in the ETF, their discounts to small-caps may narrow," said Qiu Dongrong, a Shanghai-based money manager at HSBC Jintrust. His US$247 million large-cap fund has beaten 83 per cent of peers tracked by Bloomberg during the past year.

Options are likely to be popular in China as a way to hedge risk and employ a wider variety of investing strategies, said Haitong's Ren, who has been working in the derivatives business for two decades. He also anticipates a boost to his firm's bottom line, predicting a potential tripling in profits if China expands options to other underlying securities.

For Li Wei, a Guangzhou-based money manager at GF Fund Management Co, the contracts will provide new opportunities to generate returns.

"Investors can profit from more diversified tools," said Li, who helps oversee 180 billion yuan.

BLOOMBERG