MC Explains: Once profitable out-of-money options now a trap for F&O traders on expiry day

When the market is rising, ideally premiums on call options should be rising because of increased demand.

On Friday, premiums for out-of-the-money (OTM) weekly Sensex put options contracts spiked even as the market recovered. The spike was abnormal, with premiums shooting up 7 to 80 times across different strikes, causing losses to many traders. For instance, the premium on the 65,200 strike jumped from a low of Rs 1.60 to a high of Rs 105.

A similar incident was seen in FinNifty options on Tuesday where put premiums surged dramatically on the expiry day, triggering stop-losses of many traders, and making strategies less profitable for some others.

Traders losing money when market moves sharply is common, but what makes last week’s developments unusual is traders were wrong-footed in those pockets of the market where there should have been the least volatility.

Through this explainer, Moneycontrol tries to make sense of what is happening out there in the derivatives market.

Why were the spikes unusual?

That is because on both days, prices of put options were rising when the market was going up. On Tuesday, the FinNifty was in an uptrend and, on Friday, the Sensex was recovering from the day’s lows. When the market is rising, ideally premiums on call options should be rising because of increased demand. Similarly, when the market is falling, premiums on put options should rise because of strong demand.

What are call and put options?

Call options allow the buyer to buy an asset at a predetermined price. The buyer can even choose not to buy, but if he decides to, the seller (or the writer, in market parlance) of the option has to honour the contract.

An example

Say, I buy a Nifty call of 19,200, when the index is at 19,100. Once the Nifty goes past 19,200, I am making money on the rise of every point from there on. It gives me the right to buy at 19,200, no matter where index is at that point. If the Nifty is at 19,500, I make a clean profit of Rs 300.

What’s a put option then?

It allows the holder of the option to sell an asset at a pre-determined price. Say, I buy a Nifty put of 19,100 when the index is at 19,200. Once the Nifty falls below 19,100, I am making money on every point fall from there on. It gives me the right to sell at 19100, no matter where index is at that point. If the Nifty is at 18700, I make a clean profit of 400.

What's in it for the person who sells call option or put option?

The seller of the call option is betting that the market won’t rise, which is why he is agreeing to sell you the asset even if the price goes up. Similarly, the seller of the put option is betting that the price won’t fall, which is why he is agreeing to buy an asset off you even if the price falls.

What’s an out-of-the-money (OTM) contract?

Options have varying strike prices with a gap of 50 or 100 points, depending on the index. An option contract with a strike price close to the spot price is called at-the-money (ATM). For instance, if the Nifty is trading at 19,200, a contract with a strike price of 19,100 or 19,300 is an ATM contract. Whereas an option with a strike price of 18,900 or 19,500 is called OTM because it is away from the spot price.

Why do traders buy OTM contracts?

The premium on OTM contracts is dirt cheap because the probability of those strike prices getting triggered is very low. For instance, if the Nifty is quoting at 19200 on expiry day, a sudden 300 point rise or fall is highly unlikely. Majority of the buyers of OTM call options and put options are treating it as a lottery. Say the Nifty moves in either direction by even 150 points, the premiums on the 300-point OTM will rise manifold.

Why do traders sell OTM contracts if the premiums are low and the risk high?

OTM sellers are betting that since the probability of occurrence is low, the risk in this strategy is low. If they collect small amounts of premium from a large number of buyers, that works out to a tidy sum.

Is there any other reason why traders buy OTM contracts?

Many traders buy OTM contracts as a hedge, and to reduce their margin obligations to the exchanges.

Let's understand that

Say, you have sold a Nifty call option at 19,200. The risk for you is the index falling sharply below 19,200. Say, you were to buy a Nifty put option of 18,900. Then any fall below 18,900 would not hurt because you would stand to make money on the put option you have bought. From the stock exchange perspective, the risk for you then is only 300 points (19,200 -18,900). So the margin money payable to the exchange would be lower say if you only had a position in 19,200 options.

What happened on Tuesday and Friday last week?

To answer that, we need to understand what is happening in the derivatives market right now. There is right now a weekly options contract expiring on every day of the week, across the BSE and NSE together. This is drawing a lot of traders who are trying to make a quick buck by taking positions just for that day.

One theory is that the sharp up-move in FinNifty on Tuesday, and the recovery in the Sensex would have caused losses to traders who had sold call options. The traders tried to offset their losses by building new positions near at-the-money options. Among the strategies would be to sell ATM put options, or ATM straddles — selling a put and a call option of the same strike price. As a hedge against these positions, the traders would have bought OTM options.

Why did that cause OTM put premiums to spike?

Most likely there would have been strong demand for OTM puts all of a sudden. That would caused the premium to surge, in the process triggering stop losses and forcing sellers of the OTM puts to cover their positions. Since OTM contracts are not as liquid as ATM contracts, the upswing would be sharper.

Who lost money?

The writers of the OTM contracts looking for easy money would have lost heavily because they would not have been expecting the spike. Also, buyers of OTM hedge would have ended up paying a much higher cost than usual, which would have made their overall strategy unprofitable. Look at this this way: if you were looking to buy a hedge at Rs 2.50 and ended up buying it at Rs 50, it would dent your profits.

Will these developments make traders wary of punting in OTM options?

Depends. For a writer of OTM options, last Tuesday’s and Friday’s developments have turned out to be a case of picking up pennies in front of a steamroller, when the gains are small, but appear almost risk free when they are actually not. But look at it from the perspective of buyers of OTM options. They would have made handsome profits in a matter of few seconds when the prices of the put options surged.

What are the key takeaways from the massive surge in OTM options on expiry day last week?

a. Buying OTM hedges on expiry day may no longer be as effective a strategy as in the past

b. Stop-losses will need to be devised more intelligently, so they don’t get triggered because of random spikes

c. Selling unhedged OTM options is definitely not a risk free strategy