Impending launch of ETF options could help to revive the Mainland market

17 July 2014   Category: News, Asia, China, Global   By Derek Au

The China Securities Regulatory Commission (CSRC) revealed in May that it is working on pilot schemes for equity ETF options, as part of its plan to promote more sophisticated investing in the Mainland. The move, due for August, is poised to fuel demand for ETFs listed in China, according to fund managers.

At their core, ETF options provide investors with four trading strategies. For those who want to bet that ETF prices will rise, they can either buy call options or sell put options. The strategy pays off if the ETF moves above a certain value, known as the strike price, by its expiration date. Similarly, investors who seek to capitalise on falling ETF prices can either sell call options or buy put options. Profits subsequently materialise if the ETF stays below its strike price by expiration date.

As ETF options support directional trading, they have a number of uses, such as hedging portfolio risk, carrying out arbitrage and narrowing ETF spread. Firstly, if investors want to hedge downside risk in the broad market, they can buy put options on a broad-based ETF. The hedging capabilities of ETF options become more prominent in the event of a broad-market selloff, as this largely hobbles any effect of portfolio diversification. 

Secondly, ETF options can facilitate arbitrage trading associated with ETFs when prices trade at discount or premium. Furthermore, ETF market makers can use options to hedge their risk when they have to take a large position on a particular ETF. Otherwise, the market makers might resort to widening the spread to compensate for the potential loss. 

Helen Zhou, managing director at CSOP Asset Management, the offshore arm of China Southern Asset Management, tells AAM’s sister magazine ETFI Asia that she believes ETF options will draw considerable interest, especially from institutional investors. 

“For instance, risk hedging is one of the purposes. Financial institutions can also deploy ETF options to create structured investment products for their clients. I think this offers another direction. So, both demand for risk hedging and investment will increase.” She adds that the introduction of institutional investors will change the make-up of the Mainland’s ETF market, which is currently dominated by retail investors. 

Ms. Zhou says that the trading of options will also spur higher liquidity in the ETF market. “If you look at the entire offshore market, especially in Asia, investors treat ETFs not only as a tool for asset allocation, but also for short-term investment purposes. There are different types of investment demand; Asian investors are more concerned about ETF liquidity. The introduction of ETF options will increase ETF liquidity and make ETFs more investible.” 

Data appears to show that liquidity issues, together with a weak market environment, have dampened regional investor enthusiasm for ETFs. According to a survey from Chinese financial data provider Wind Information, outstanding units of ETFs listed in the Mainland had dropped by 6.4% year-on-year, as of the end of May. Asset managers expect that an increase in ETF liquidity, driven by trading of ETF options, can spur the Mainland market. 

One of the major breakthroughs in China’s financial sector, particularly in terms of derivatives, in recent years was the launch of CSI 300 Index Futures in 2010. The launch of ETF options combined with CSI 300 Index Futures promises to provide asset managers with more complex investing strategies. For example, they will be able to execute pairs trades between options on the broad-based index and CSI 300 Index Futures in order to capture arbitrage opportunities. 

The Shanghai Stock Exchange (SSE) currently offers simulated trading of two options on equity ETFs tracking the SSE 180 Index and the SSE 50 Index, respectively, and three options on individual stocks. The two indices in question cover the bourse’s major listed companies. Ms. Zhou expects the launch of ETF options will arrive before that of stock options, as she says the former is less likely to be at risk of insider trading. 

Ms. Zhou believes that launching ETF options is ultimately part of Chinese authorities’ plan to encourage a more sophisticated financial sector. “I believe it is consistent with the Chinese regulators’ initiatives to promote financial innovation. I feel the Chinese financial market and capital market in China are advancing very rapidly, but the development of derivative products is relatively slow.”