As trading activity in China’s stock market wanes, one part is booming.
The number of options changing hands on the China 50 Exchange-Traded Fund swelled to a record last month, data compiled by Bloomberg show. Turnover on Shanghai’s equity exchange went the other way, sinking to levels last seen regularly in 2014. For Old Mutual, the options trading shows that investors aren’t convinced by the 13% rebound in Chinese shares from their one-year low.
“People are bearish,” said Joshua Crabb, head of Asian equities in Hong Kong at a unit of Old Mutual. “However, they’re sitting there and seeing some of these stocks go up a long way. If you’re very bearish and very defensively positioned and saying maybe in two months if we get some better data and this continues, I could be hurt - I might pay a little bit of insurance to try and protect some of that.”
The ETF is the only mainland security on which options trading exists, with regulators allowing the contracts in early 2015. Volume has grown steadily ever since, weathering China’s $5tn stock bust and an official crackdown on futures that saw transactions plunge 99%.
“Index futures trading volume sank since last summer after measures were imposed to restrict over-speculation,” said Guillaume Derville, head of Asia Pacific equity and derivative strategy at BNP Paribas SA. “Options became the alternative for leveraging or hedging purpose.”
The Shanghai Composite Index has rebounded from its January 28 low as economic data and the nation’s currency stabilised. 
The gauge is still 42% below its peak in June and turnover has waned, with daily volume this year on the Shanghai exchange less than half of the average in 2015. 
The index rose 0.2% at the close last week, on volume 26% below its 30-day average.
Open interest in China 50 ETF options surged to a record of more than 750,000 contracts last week, while one-day volume also hit an all-time high last month, according to data compiled by Bloomberg. 
An average of 115,664 call options changed hands each day in April, while investors traded 93,988 puts. Lewis Wan, chief investment officer at Pride Investments Group Ltd in Hong Kong, says the contracts are attractive to speculators who’ve been shut out of the futures market by regulatory changes and want to bet on stocks without paying for them upfront.
“There are a lot of limitations in the futures market but if options provide similar leveraging, that may attract retail investors,” said Wan, whose firm oversees about $250mn. “The amount of investments by some small to medium enterprise investors is big. Those are sophisticated retail investors who want to use a lot of tools to leverage up in the market.”
Trading in the options suggests investors are about evenly split between those betting on gains and those buying protection against declines. The implied volatility for one-month contracts that profit if the underlying ETF falls 10% was just 0.17 points more than bets on a 10% gain in the stock on Tuesday, according to data compiled by Bloomberg.
While option volume on the China 50 ETF is booming, flows into the underlying fund have dried up, with investors pulling money out for a third straight month in April. Traders may be exiting the ETF as divergence in individual share returns on the mainland encourages them to attempt to pick stocks rather than buy an index, according to Old Mutual’s Crabb. China is the world’s worst-performing major equity market this year.
For options to thrive in a tightly controlled market such as China, investor demand is not enough. Regulators are aware that the nation’s capital markets need to be more sophisticated, and they are testing the water with options first before rebuilding the futures market, according to Capital Link International Holdings.
“In order to get deeper capital markets you need to get into derivatives,” said Uwe Parpart, the chief strategist at the investment bank in Hong Kong. “From a regulatory standpoint, if more people get used to understanding and dealing with options, that’s a positive, so why not encourage it.”