After more than two years of preparation and repeated delays in the launch, the free market socialist economy of China is expected to commence options trading (for additional reading, refer to Options Basics: Introduction ) on February 9, 2015. Anyone from the free market capital economy (For more insight on free market theories, see Free Markets: What’s The Cost? ) may be amazed to know that the world’s second-largest economy has not yet enabled options trading (for related reading, refer to 6 Ways To Make Better Options Trades ), but China believes in taking a cautious, step-by-step approach.

We provide an overview of China’s options market, covering important points such as the existing state of the options market, reasons for the delays, the steps taken by Chinese authorities to open the options market, the initial phase and building blocks, primary beneficiaries, the impact on the overall financial markets and the expected developments.

Reasons For Delay In Opening The Options Market

The socialist market economy of China (for related reading, refer to Socialist Economies: How China, Cuba And North Korea Work ) has managed to grow with a fine balance between collective socialist and free market capitalist approach, making it the world’s second-largest economy (and on its way to becoming the first). However, this balance has come at the cost of various important decisions and reforms being delayed due to the government’s control and cautious approach. Stocks and futures do trade on a few Chinese exchanges, but options trading is yet to start in the country. Historically, exchanges in China have taken a considerable amount of time to begin trading. For instance, the China Financial Futures Exchange (CFFEX ) was established in 2006 solely for the development of the financial derivatives market but it took four years to commence trading its first product, while stock index futures started trading in 2010. Today, the CSI 300 equity index futures remain the only stock-based derivatives available for trading in Chinese markets.

Having been delayed by several years, the options market is now taking shape in China due to global pressure and financial requirements. No major financial economy of the world is running without an options market, and derivatives continue to play an important role in the global economy as well as local markets. However, China is not willing to allow market participants (including foreign investors and traders) to take over the entire market, and is preparing for local expertise, which is a major cause of delay.

Other challenges lie in the backdrop of unwanted developments. The South China Morning Post (SCMP) reported that growth of the Chinese margin trading business did enable revenue increase for brokerage firms but that came at the cost of small investors’ money. Associated reports of the China Securities Regulatory Commission (CSRC ) recently banning major brokerage firms from opening new trading accounts owing to the violation of rules have led to more speculative concerns about the launch of new derivative products such as options.

The case of Indonesia has served as a good benchmark. When Indonesia opened options in 2004, it landed with a major failure due to limitations imposed on profit from options, as market participants did not have sufficient knowledge of trading relatively complex options. This led to the closure of options trading in 2006.

Regulated Approach

Amidst perceived challenges, leading to a cautious approach and delays, China is well on its way to start the options market and related trading activities within the regulated purview. The draft of a few important requirements and guidelines is already set for options trading, with the basic rules as follows:

The Shanghai Stock Exchange mandates that individual investors have a minimum 500,000 Chinese yuan in cash and shares in a single account for trading options. Although China has around 50 million active equity trading accounts, barely 5% of these qualify on this parameter. Of those that do, interest may be limited due to multiple factors such as a lack of liquidity, knowledge or even interest in trading options.

Additionally, reports indicate that aspirants will be required to qualify three progressive tests where each level of qualification will allow options trading for a pre-defined purpose.

• Level one qualification will allow using options trade to hedge existing holdings
• Level two will allow taking long only options positions (including speculative trading )
• Level three will qualify for full options trading (including shorting )

Other market level requirements will include training, market making and consulting to develop the much-needed local expertise. China has a defined framework in place for slow and guarded advances, aimed at securing the options market from the start and paving the way for slow as well as steady development over time. This, for an outsider from a free market capital economy, may indicate too much control.

Initial Phase And Building Blocks

Exchange traded funds or ETF. known as one of the most efficient investment options for a passive investing approach, have failed to attract common retail investors in China who tend to go for small cap companies. The interest in direct investment in large cap stocks is also relatively low. (For related reading, see Understanding Small- And Big-Cap Stocks ). Chinese regulators are working systematically to address this problem. The SCMP reported. “The first stock option will be based on the exchange-traded fund (ETF) of the blue-chip SSE50 index. which covers the largest publicly traded firms on the Shanghai bourse.” The aim is to shift investors’ interest towards ETF and large cap markets, reducing the higher risk they are exposed to in small cap companies. With options available as hedging tools (for additional reading, refer to Hedging Basics: What Is A Hedge? ) against the underlying holdings of select ETFs, even speculative traders will end up holding ETFs, serving the purpose at a larger level and laying a solid foundation for options trading, with increased investments in ETF and large cap stocks.

Later, options on other products such as the SSE180 ETF or even on single stocks will be introduced in a phased manner. This approach is aimed at providing the much-needed flexibility to regulators – if things do not pan out as planned, the remaining phases for introducing other single stock-based options can be postponed.

To diversify further and offer multiple independent marketplaces with open and healthy competition for traders and investors, regulators plan to introduce index options on the China Financial Futures Exchange and individual stock-based options on the Shanghai Stock Exchange. Having multiple markets allows risk mitigation at the administrative as well as regulatory levels and offers opportunities for further scaling and choice to traders.

The Financial Times reported. “The Shanghai Stock Exchange has conducted simulated trading of options based on the CSI300, Shanghai 180 and Shanghai 80 exchange traded funds”.

Beneficiaries

Brokerages firms trading options will obviously be the main beneficiaries once the Chinese options markets become operational. But until markets stabilize (which will take a long time, given the step-by-step approach), there will be a lot of opportunities for other participants as well.

Already, global marketmakers have been working with their Chinese counterparts to train them for the required options business. Over time, with a gradual increase in options market participants (including retail traders), trading volume will rise, leading to more opportunities for firms to offer options brokerage services and trading platforms .

Technology firms are expected to roll out new and updated versions of software and trading platforms to enable options trading. With option combinations. strategies and associated quantitative trading. strategies such as delta hedging and algorithmic trading will pave the way for more entrants into Chinese markets.

Most banks, brokerage firms and individual market participants will start from the scratch in China, enabling tremendous opportunities for financial market education and training firms. There is already a lot underway, with global trading firms getting their Chinese employees trained on options trading by their global peers and global option consultants grabbing opportunities for training local Chinese trading houses. Moreover, there are opportunities in the future for individual retail traders and investors who may eventually board the bus for trading options for hedging. arbitrage or simply margin trading on leverage (for related reading, see Trade High Cost Stocks Like Apple Through Low Cost Options ).

Trading and expansion opportunities will continue to be available even after the option market starts functioning. The requirement for clearing the three levels of exams will be another target area for training firms.

Arbitrage opportunities exist on larger scale, as the stock, futures and other financial markets in different domains (such as commodities) currently operate independently (and are expected to continue to do so). The dynamics of options trading create enough opportunities to benefit from available arbitrage in this scenario, which is one of the primary reasons for so much interest in China by global options trading firms and consultants. The mainland is on its way to build an upgraded infrastructure for wide facets of trading and investments.

Impact On Market

Due to restricted options trading focused on blue chip -based ETFs during the initial phase, trading is expected to be boosted in the top 50 blue chip stocks. Trading volumes are likely to rise significantly for the top 50 heavyweights such as ICBC and PetroChina (PTR ).

Gold may soon become the first commodity as an underlying for options trading, as it is a very popular investment and a fund raising asset in China. Although High Frequency Trading (HFT ) will not be the priority in the initial stage, as the focus remains on getting the right start, it will eventually make way through large brokerage firms and trading houses.

Currently, all kinds of investments in Chinese financial markets are forced to follow long only investment strategies due to the non-availability of stock/index-based derivatives or any other short position strategies. This will soon change, with the introduction of options, which will enable many option strategies and combinations.

Road To The Future

In China, slow is the word for options trading amidst a government-controlled economic system. With a steady approach, the government is expected to keep pointers in the positive direction, indicating continued market reforms towards greater liberalization of capital markets.

The options market in China will have global reach. The SGX is expecting a head start by being the first exchange outside China to be allowed options trading, based on Chinese indices and equities. Bloomberg recently reported that the exchange is looking to start trading Chinese equity-index options and “is in talks with the China Securities Regulatory Commission on when the Singapore bourse can introduce options on the FTSE China A50 Index, with approval likely to come after such products are introduced on the mainland”.

The Bottom Line

China is known as a socialist free market economy that has gradually opened up, enabling foreign investments, profit taking and investor friendly reforms, still remaining within the purview of the government. Financial derivatives, such as options, are known to be the double-edged sword, which need a fine balance of regulations and free efficient market participation. China is taking a cautious, step-by-step approach to ensure that the introduction of these financial instruments does not lead to a setback to its financial markets and they remains within regulated control.