Markets

Christopher Langner is a markets columnist for Bloomberg Gadfly. He previously covered corporate finance for Bloomberg News, and has written for Reuters/IFR, Forbes, the Wall Street Journal and Mergermarket.

Investors in China are discovering that a great way to take a position in a market without fully committing is by simply buying options. If only there were more of those, maybe authorities wouldn't have to intervene so much. Sure, there may be a few more equity crashes along the way, but ultimately, the use of derivatives could transform Shanghai and Shenzhen into true investment destinations.

The number of options changing hands on the China 50 Exchange-Traded Fund swelled to a record last month, Bloomberg News reported today. The contract, the only one of its kind in China, celebrated its first anniversary in February. China didn't allow trading of index futures until 2010. They became hugely popular, and attracted the scrutiny of Beijing after last year's stock-market rout.

Sudden Death
The main index future contract traded in China saw record volume until the stock market crashed and regulators limited retail participation
Source: Bloomberg

In September, the China Financial Futures Exchange ruled that opening more than 10 contracts on a single index-futures product on the CSI 300, SSE 50 and CSI 500 indexes would be defined as ``abnormal trading''. The move killed what had rapidly become the world's biggest stock-index futures market, and open interest fell back to 2012 levels. 

The CFFE's decision appears to have been prompted by what was seen as excessive speculation in the derivatives market, which may have exacerbated equities' downward spiral. What authorities failed to see was that if futures were helping the correction, then they were merely fulfilling their role of making the market more rational, and efficient. 

Prior to the crash in early June, the CSI 300 composite of stocks listed in Shanghai and Shenzhen had rallied 52 percent since Dec. 31, 2014:

All That Rises
By early September, when Chinese regulators limited futures trading, the CSI 300 had halted its fall
Source: Bloomberg

Average daily volume in that period was 34.2 billion yuan ($5.3 billion), almost six times the same period a year earlier:

Hyperactive
Average daily volume in the period from Dec. 31, 2014 to June 8, 2015 was almost six times that of a year earlier
Source: Bloomberg

That's a great market to be in while it lasts, but it's simply not efficient, which is why by June there was so much open interest in the few stock-index futures available. Any sane investor would at that stage start hedging bets.

But investors in China today have scant hedging options. Shorting is expensive and limited, leaving derivatives. There is, however, only one index-option contract and zero for individual stocks, and futures are few and far between.

What difference does hedging really make? For that, take a look at the paths of the U.S. publicly traded iShares China Large-Cap Exchange-Traded Fund, which has more than 1,000 options and some 215 futures contracts associated with it, and the Shanghai publicly traded China 50 ETF, which tracks an almost identical index but only offers 82 options to bet on:

Set Them Free
A U.S. listed exchange-traded fund meant to track the FTSE China 50 Index peaked two months earlier than its Chinese peer
Source: Bloomberg
* Indexed to May 6, 2014 for comparability.

It's also worth noting that the swings for the U.S. listed ETF weren't as wild. And while investors in North America didn't reap as many profits on the way up, they lost a whole lot less on the way down.

As MSCI weighs including the onshore-traded shares of Chinese companies in its benchmark indexes, the availability or otherwise of options is going to become a more pressing subject. MSCI has already said it wants less intervention before it would feel comfortable bringing those stocks on board. It should start pushing harder for derivatives too. After all, a market only starts to become more mature, and rational, once it has options.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Christopher Langner in Singapore at clangner@bloomberg.net

To contact the editor responsible for this story:
Katrina Nicholas at knicholas2@bloomberg.net