Academic journal article Business: Theory and Practice

Volatility Informed Trading in the Options Market: Evidence from India

Academic journal article Business: Theory and Practice

Volatility Informed Trading in the Options Market: Evidence from India

Article excerpt

Introduction

While financial theory has well emphasized the role of derivatives in trading a gamut of risks in financial markets (such as equity risk, exchange rate risk, interest rate risk, and credit risk), their role as a vehicle to trade on information has emerged as an additional economic function in empirical financial research. Market microstructure theory suggests that, price movements are largely caused by the arrival of new information and their incorporation into market prices through trading. A sizeable literature (1) have documented the use of derivatives on directional information and their role in predicting future price movements but, the corresponding issue of trading of derivatives based on non-directional information, like information about future volatility, remains to be examined in literature in detail. Since volatility forecast is central in finance due to its use in pricing of derivatives as well as for financial activities like portfolio selection and asset management, a study on volatility informed trading of derivatives becomes essential.

The theory of options pricing is unclear about the exact nature of volume-volatility relationship (Sarwar 2005). Black (1975) argues that informed traders may be attracted towards options due to the economic benefits like lower transaction cost and higher leverage associated with trading options. As a result, the option trades may be informative about future price volatility due to the fact that pricing options requires volatility as an input parameter. Conversely, researchers also argue the hedge related use of options arising due to asset's price volatility, which may cause option trading to follow the price volatility. This study examines the relationship between implied volatility and the trading activity of options to understand the kind of use options have in the Indian market and thus contributes to the literature on the price discovery function of derivatives.

Options are securities with non-linear payoff structure. As a result, a volatility informed trader can only bet on his information in options market (unlike a trader with directional information who, besides options, can also trade stocks or futures). Lack of empirical proof of this fact stimulates us to conduct this study. Moreover, as the focus of microstructure literature has been on intraday pattern rather than inter-day dynamics, studies using publically available data with daily frequency are very sparse. Besides, a large number of small traders who are unable to incur the cost to access private information trade mostly on freely available information. Thus, a study investigating the volatility related information contained in options trading using publically available daily data is imperative. It would benefit the traders at large in maximizing their payoffs. The data of S&P CNX Nifty index options traded on National Stock Exchange (NSE), India is employed for this study. This study, to the best of our knowledge, is the first to address the issue of volatility informed trading of options in Indian market.

Our study period i.e. January 2004-December 2011, is considerably longer period compared to that of the existing studies and includes years of up, down, and recovery trends in the market. Derivatives are popular instrument to trade on negative news due to short selling restrictions in spot market. Moreover, options in different moneyness categories offer different leverage and liquidity and they also have different future volatility estimates (Shaikh, Padhi 2014). These factors may have implications for participants in the market as it can significantly affect their payoffs. Thus, we consider market trends and option's moneyness classes in our analysis to uncover a particular trend or moneyness class (if any) which is preferred by informed traders or hedgers.

The next section presents a brief literature review. Section 3 highlights the objective of the study and section 4 discusses, in detail, the data and methodology used for this study. …

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