Shanghai ETF option volatility spikes on China market fears

A crackdown on margin financing strengthens bearish sentiment

Implied volatility of the Shanghai Stock Exchange (SSE) 50 exchange-traded fund (ETF) options jumped to a record high this week on fears the recent rise in China equity values is set to reverse, combined with a further crackdown by Chinese regulators on margin trading, according to market participants.

The implied volatility of SSE 50 ETF options saw consecutive jumps during the first three trading days this week. Figures from China Securities Index show that the 30-day weighted average implied volatility soared to 45.88 on April 20 and continued to rise to 52.48 the next day before hitting an all-time high of 53.22 on Wednesday – double the realised volatility of the underlying index.

While the options' volatility spiked to over 50%, the realised volatility level of its underlying SSE 50 ETF remains at 26%. While it is normal for implied volatility to outrun its realised peer the size of the dispersion in these two numbers is not normal according to a Hong Kong-based global head of equity derivatives who describes the spread as "unusually wide".

Meanwhile, the daily trading volume of the options contract increased to 60,482 on Monday – an 81% increase compared with the average volumes in the first three weeks of April, a scenario that Huang Min, Shanghai-based co-head of financial derivatives at Cofco Futures says is an unmistakably bearish signal.

"That both volatility and trading volumes skyrocketed recently signals investors' expectation of strong uncertainty of market movement in the short term," he says.

Huang's view is supported by Jiao Mingjuan, analyst at GF Futures in Guangzhou who says that the recent rise in A-shares – renminbi-denominated equities traded on the Shanghai and Shenzhen bourses – is starting to concern investors and making markets fragile.

"A-shares were rising aggressively and investors have become increasingly concerned about the downside risk. Any negative news at this point may trigger a fall and drive up market volatility."

The trigger Jiao refers to was the move by the China Securities Regulatory Commission (CSRC) last Friday when markets had closed to ban securities brokers from using so-called 'umbrella trusts' in margin financing. Umbrella trusts are a leveraged strategy that enables investors to punt up to five times their initial capital, versus a flat exposure via a standard brokerage account. Regulators fear that retail investors who made losses via umbrella trusts would liquidate their positions in a downturn thereby magnifying the impact of a bear market.

Market reaction was swift to the CSRC move with the Hang Seng China Enterprises Index falling by 3.3% and FTSE China A50 Index futures for April delivery on the Singapore Exchange tumbling 6% last Friday. The onshore market responded to the crackdown on Monday trading with the Shanghai Stock Exchange (SSE) Composite Index falling 1.64%.

Lu Peili, managing partner in the hedge fund department of Qilu Securities Management in Shanghai, says that this abnormal spread signals a tension between bearish and bullish market sentiment and is a strong signal to exit the market.

"When ETF option volatility hit 50%, we advised our clients to close out their positions immediately as it is just too expensive," she says. However, Lu adds that while people are exiting the market for risk management reasons a large portion of offshore and domestic investors are still bullish about China's stock market.

Last Friday's crackdown was the second time Chinese regulators have looked to rein in margin financing and follows the January CSRC move when it punished securities brokers for breaching margin trading rules. That move resulted in a 7.7% fall in the SSE Composite Index, the biggest one-day plunge since 2008.

Following closely on CSRC's action, China's central bank cut the reserve requirement ratio by 100 basis points last Sunday, the timing of which is interpreted by market participants as a way to alleviate investors' fears and demonstrate the government's intention to back up the nation's equity market although bubbles have been piled up.