The Hindu Business Line : Options for the week

The introduction of such short-term instruments may have a positive feedback on the monthly-settled equity derivatives market. That may, perhaps, prompt hedgers to enter the market in a big way. The economic benefit of derivatives would then be optimally utilised.

Market structure: At present, derivatives are primarily used as an instrument to take a bet on the directional movement of the underlying. A trader may for instance buy a futures contract if she is expects Reliance Industries to move up. Alternatively, she may buy call options or sell put options on the stock.

The problem is that speculators prefer futures to options for two reasons. One, futures is easier to understand and trade. And two, options are not price-efficient.

The second factor is important. Options are typically highly priced. In technical terms, the option implied volatilities are far higher than the volatility of the underlying. This increases the risk for traders and hedgers.

Suppose the 25-day historical spot volatility for Reliance is 40 per cent and the implied volatility of a 25-day put option is 60 per cent. A trader who buys a put option essentially pays 20 percentage points more than the historical volatility.

Even allowing for the margin of error in forecasting volatility, the trader or a hedger runs a huge risk. What if the implied volatility later declines or reverts to the historical volatility? In that case, the position may not be profitable even if the stock were to decline as expected. This risk is termed as the volatility or the vega risk. The point is that the vega risk will be lower if the options are more efficiently priced.

Positive feedback: The reason options are rich is because the volumes are low. But volumes are low because options are rich. In other words, the factors are intertwined.

The market therefore needs a good reference model to enable investors to efficiently price options. The weekly-settled options could perform this role. Here is why.

Speculators are likely to favour the weekly-settled contracts. The reason is that option premium will be lower because of lower time value (one week against one, two and three months in the existing case). If volumes increase in the weekly-settled contracts, liquidity will improve. This will result in narrow bid-ask spreads and higher price efficiency.

Now, the primary difference between the weekly and monthly contracts is the time value. Investors can use the actual price of the weekly-settled options and plug-in the time to maturity into a standard option valuation model to obtain a fair value of the monthly contract. In the initial period, a liquidity premium may be added as well. The fair value so calculated can be used as a reference point for the monthly contracts. This will result in a more intelligent bid-ask quotes and will gradually result in a more price efficient monthly-settled options market.

A price-efficient options market will attract hedgers. At present, these investors stay away from the market because of the risk of over-paying for the hedge.

A market with hedgers and speculators will no doubt provide for better pricing and will also serve the economic benefit of lowering financial risk.

Volatility: One point that needs to be addressed here is whether introducing weekly-settled options will increase the spot market volatility.

The advocates of this hypothesis claim that derivatives has led to high degree of volatility in the spot market, especially during the contract expiry.

The argument is this: Traders close their near-month positions and open fresh positions for the next month.

The demand for the next-month contracts may lead to some degree of intra-day volatility in the derivatives market. This is expected to have a ripple effect on the spot market.

A qualitative test on the futures and spot market data does not, however, support this hypothesis. The intra-day volatility measured as the difference between a high and low price during a trading day is not higher on the contract expiration date.

Even on a closing basis, the market returns, measured by the Nifty index, is not different on the contract expiration date. There is, hence, no reason to suspect a priori that the introduction of the weekly options will lead to more volatility in the spot market.

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