Derivatives traders in FinNifty weekly options contracts were baffled by the spike in premiums of many out-of-money (OTM) put strikes on the expiry day on Tuesday. That is because the premiums for put options flared up in a rising market, when logically they should have been falling.
Put options give the holders the right to sell at a pre-determined price. So, if you own a FinNifty put for 19,800 strike, and the index falls to 19,600, you get to make a profit of Rs 200 (19,800-19,600).
On Tuesday, the premiums shot up by as much as 40-50 times over the previous closing levels, which is ridiculously high for contracts way off the market price and set to expire in a few hours.
For instance, the premium on puts of 19,400 strike swung from low of few paise to a high of Rs 45, that on 19,300 strike hit a high of Rs 48.50, and the premium on the 19,300 strike surged to Rs 66. In contrast, the highest premium for a put option at 19,600 strike, which still had a better probability of being triggered, was Rs 10. In other words, traders were betting crazy amounts on an event unlikely to happen, and betting less money that had a higher probability of happening.
It is when the market is in a downtrend that traders buy put options to protect the downside in their positions, and the huge demand for puts send the premiums soaring. So, there should not have been a stampede for put options on the FinNifty when the index was rising on Tuesday.
And, even if there was a sudden demand for put options, it should ideally be for at-the-money (ATM) contracts, which means in contracts whose strike prices are close to the current market price.
The anomaly has left traders puzzled, though nobody is clear as to what caused the phenomenon. There are multiple theories doing the round, but nobody is certain. The starting point most likely would have been the sudden 110-point rise in FinNifty from 19,688 to 19,800 between 12:02 and 12:15 at noon. This led to a sudden surge in demand for call options, causing huge losses to writers of traders who had sold call options (call writers, in market parlance) at lower prices.
The holder of a call option has the right (not obligation) to buy at a pre-determined price. The value of a FinNifty call option of 19,600 strike will become valuable if the index climbs to 19,800, because the holder gets to buy the index at a 200-point discount to the current market price. But it is bad news for the call writer who has sold the option at a low price, not expecting the surge.
“It is likely that call writers who suffered losses would have tried to offset their losses by building new positions near at-the-money options - possibly selling ATM put options or new ATM straddles. In doing so, traders would also buy the OTM put options as hedge for the ATM options sold." Singapore-based derivatives trader Ashish Gupta told Moneycontrol. When a trader sells ATM options, he earns a higher premium.
“What followed was a sudden rush to buy OTM put options as a hedge, and most likely it would have been algo orders with instructions to buy at market prices. Since there are not too many options sellers in far OTM, the aggregate demand at one go would have sent the prices soaring,” Gupta said.
He said that the prices surged and stabilised within minutes.
“It could have set off a vicious cycle as many stop-loss levels could have been triggered, forcing put writers to cover up their positions at whatever prices available, in turn triggering more short covering,” Gupta said.
Chatter in the market initially was that there could have been some freak trades.
“They are not freak trades because the surge has been seen in put options across the board,” said Kapilan T, a Chennai-based derivatives trader.
Seasoned traders say the number of traders looking to make a quick buck on expiry day has been steadily rising over time. The NSE has weekly options contracts expiring on all days except Friday, and the BSE has a weekly options contract (Sensex) expiring on Friday.
One factor that has been a big draw for options sellers is that the market has not been too volatile for nearly three years now since the panic of 2020 when Covid struck.
But that may be changing.
“It was like chain reaction, where due to some reason puts spiked and because of that, SL (stop losses) of other algos started to trigger,” tweeted Amit Jain of AlgoTech, an execution platform for algo traders. “Today it may sound rarest of rare but since algo players are increasing and all day (of week) expiries, this may repeat. People taking massive risk by selling penny ATM premiums is not justified,” he said.
In an interview to Moneycontrol last month, F&O trader and founder of Squareoffbots.com, Rajendran Kirubakaran had spoken about some of the pitfalls that new entrants to the derivatives arena were overlooking. “Many of them (new entrants) are pursuing high-risk strategies without fully understanding the implications,” he had said.
“For instance, imagine you have a trading strategy, and according to historical data, it indicates that the maximum drawdown is typically around 10 percent. In a single trade, you might only incur a loss of 1 percent or 2 percent. This is what your trading system, based on historical analysis, suggests. If it happens to be on a contract like FinNifty, you have barely two years of data. During these two years, there hasn't been a wild move in FinNifty.
But the major problem I'm seeing now is many traders are new to systems trading, so they just blindly believe what has happened in the past is going to happen in the future. They need to consider the worst-case scenario when developing a trading system and accordingly design their money management rules,” he said.
Also read: Frankenstein algos: Exchanges, SEBI need to spell rules for retail traders
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