Academic journal article IUP Journal of Applied Finance

Undercurrents of Options Trading

Academic journal article IUP Journal of Applied Finance

Undercurrents of Options Trading

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Introduction

An index of a stock market is the numerical reflection of a collection of stocks and its value changes in relation to the stocks that form part of the index. Indian stock market witnessed derivatives trading only by the middle of 2000 with the introduction of index futures and index options. An index is significant to evaluate the performance of investments in a relevant market. S&P CNX Nifty constitutes 50 stock indices representing 22 sectors of the economy and is used for benchmarking fund portfolio, index funds and index-based derivatives. As on March 30, 2012, 65.57% of the free floating market capitalizations of NSE-listed stocks were embedded in S&P CNX Nifty. Trading on index options was introduced on June 4, 2001 by NSE and these option contracts are European style and cash settled based on S&P CNX Nifty's popular market index. To avoid big losses, large fund managers hedge their cash position using Nifty options.

Large amount of trading has let the market become volatile. Thereafter, the volatility instruments have emerged in the market to safeguard risk-averse investors against uncertainties arising out of volatility in asset prices. The value of implied volatility of derivative contracts is gauged by volatility instruments which are basically financial instruments. The benchmark of stock market volatility, Indian VIX, was introduced in April 2008 by NSE. The computation of India Volatility Index (India VIX) is from the best bid and ask quotes of "out-of- the -money", near and mid-month option contracts of Nifty. The perception of investors towards near-term market volatility has been determined by India VIX.

Likewise, liquidity is essential for markets to develop, and lack of liquidity may lead to inadequate trading. Thus, any price movement in the market is determined by the decisions of multitude of traders. Unlike stock trading, in options trading, open interest tells the number of outstanding contracts that exist for a particular stock at the end of the day. The increase or decrease in the number of unexpired or unexercised contracts on a given day is represented by open interest. In call and put options of various strikes, maturing in a given month is mounted into open interest from the time trading was introduced, but it leaves the investor expectant about the probable closing stock price on the maturity date.

Black (1975) suggested that informed traders might prefer trading in options market to stock markets because of the economic incentives arising out of lower transaction costs, less capital outflow, lower trading restrictions, limited loss potential, and higher leverage. Therefore, volatility index, index options, index and open interest are considered as means for informed traders to trade on their information and for others to discover that information. This study would like to focus on the leading indices that force trading in the options market.

Literature Review

An impressive literature is available on the interlinkage between variables from derivatives segment and from the underlying cash market. These research studies can be broadly classified into two areas: the first area consists of the impact of volatility index on underlying cash market, followed by derivatives market (option index) impact on underlying index (Nifty), including lead-lag relationship between options and cash market. Consensus exists among different researchers on options trading having a significant impact on underlying markets, though the reasons behind this are still inconclusive. The second research area constitutes the trading volume of options market. Literature provides evidence on a considerable research devoted to trading volume of derivatives market. Research studies on information content of non-price variables of derivatives market gained momentum later.

Fleming et al. (1995) examined the behavior of the volatility index and found that volatility indexes (VIX), which are an average of index option implied volatilities, indeed appear to be useful proxies for measuring volatility in the market. …

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