Despite being an organized stock market for over 100 years, the financial derivatives market in India is in its nascent stage and therefore, less explored. This paper attempts to examine the relationship between the stock market characteristics and the option market liquidity, using data for equity options and underlying stocks, in the Indian context. It was found that while option liquidity is positively related to stock price, stock liquidity and stock return volatility, it is inversely related to uncertainty in the information environment measured by the company size. The results are robust to alternative measures of option liquidity and different types of option. The findings are in conformity with those of the developed markets, and shall be useful for institutional investors, who actively trade in the options market owing to its lower transaction cost, leverage advantage and short sale restrictions on the underlying stocks.

Financial derivatives have become extremely popular in the developed markets of the world, and witness large trading volumes on the global exchanges. They are used as powerful risk management tools for hedging risk in the corresponding spot market. During last two decades, the financial derivatives markets have grown tremendously, in terms of the variety of instruments and their trading volumes.

In India, derivatives explosion occurred with introduction of index futures on National Stock Exchange (NSE) in June 2000. This was followed by commencement of trading of index options as well as equity option in June and July of 2001. Indian derivatives market saw the introduction of individual stock futures in November 2001, while the interest rate futures were available for trading from March 2003. Index futures and options were introduced based on S&P CNX-50 Index, an equity market index constructed by National Stock Exchange of India. Futures and option contracts based on CNX-IT and Bank NIFTY indices were launched in August 2003 and June 2005 respectively. After introduction of financial derivative products in India, the indigenous trading system known as Badla was banned in July 2001, as it caused excess speculation. It was instead fully replaced by the internationally acceptable option trading system, which encourages the investors to hedge portfolio risks systematically.

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