The unshakable faith of the first-time retail traders in India’s ongoing bull market faced its sternest test on February 24 after Russia’s invasion of Ukraine caught them on the wrong foot.
Vladimir Putin’s announcement of military action in Ukraine caused a more than 300 points gap down opening for the domestic stock market, which was in line with the carnage seen in other Asian markets and European markets later in the day. The Nifty 50 index eventually closed lower than its opening level, ending down by 4.9 percent at 16,247.95.
Germany’s Chancellor Olaf Scholz termed Russia’s invasion as a ‘dark day for Europe’ while US President Joseph Biden said the action was ‘unprovoked’.
For retail traders, it was a nightmare.
False Sense of Security
The late recovery on February 23 from the day’s low for the market following Russian President Vladimir Putin’s fiery speech and recognition of two separatist regions in Eastern Ukraine had lulled retail traders into a false sense of security.
Retail traders added 205,289 contracts on the short side in the put options of the Nifty 50 index on February 23 assuming that selling pressure in the market was more or less exhausted given that the index had fallen for six consecutive days.
A put option gives a trader the option, but not the obligation, to sell the security at a pre-determined price and time. Shorting a put option of a security reflects the trader’s view that the downside in the market was limited and therefore, he will write such contracts in the hope to earn easy premiums.
“It has become a common phenomenon among new retail traders that option writing (selling) earns a lot of money. So, every month they are going short on put options because the market is has seen a linear move over the past one year,” said Ruchit Jain, lead research analyst at 5Paisa.
Volmaggedon in Nifty options
Putin’s move, however, amounted to a mini black swan event for the global equity market. Mini because even though most politicians did not expect Russia to invade but the US and Ukraine had consistently warned of Putin’s intent to eventually breach Ukrainian borders.
The surprise move by Russia led to a sharp spike in implied volatility of out-of-money put options of the Nifty 50 index expiring on March 31. The same put options that were sold by retail traders a day before in the hope that the market won’t fall rapidly.
In 2018, a similar sharp spike in volatility had led to the closure of many volatility-focused funds leading investors to term the event 'volmageddon'. At home, the volatility index, India VIX, soared to a 20-month high today to 31.98 points, up 30 percent.
The premium on the out-of-money put options of the Nifty 50 spiked 194 percent to 264 percent in today’s session as traders scrambled to buy hedges against a further decline in the benchmark index in the coming weeks as the crisis in Ukraine turned in a full-blown war.
With put options writers exposed to potentially unlimited losses, the surge in demand for such options forced them to sell part of their profitable positions in the cash market to avoid blowing their trading account, dealers said.
Dealers said that the forced selling by retail traders in the cash market to cover for their losses on the derivatives side was the major driver for the extended selling in the last hour of the session that led Nifty 50 to close nearly 5 percent lower, the biggest one-day fall in two years.“This is a new thing which they have seen today and of course, today was a big lesson for all the newcomers who have entered the market in the last one and a half years,” Jain said.
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