Trading is all about deciphering patterns and inter-relationships. The problem is, it is very easy to pick up spurious patterns.
01-Nov-2006 •Devangshu Datta
Trading is all about deciphering patterns and inter-relationships. The problem is, it is very easy to pick up spurious patterns. A set of evenly-weighted coin-tosses may feature a long string of successive heads or tails. Ask any Test captain who has lost five successive tosses calling the same side of the coin! It's easy to see 'patterns' in random data. Bear this in mind while taking a little trip through data generated in the futures and options markets (sourced from the NSE's statistical reports). We may be able to test a few logical hypotheses. On the other hand, we may pick up spurious patterns!
The participants in F&O markets consist of hedgers, arbitrageurs and speculators. It ought to be possible to figure out, which type of participant has the most say. Here's the logic underlying our examination of available data
If the F&O market is dominated by hedgers, spot and F&O market signals should be inversely-related. For example, if the spot market is up, there should be net short positions (that is more put open interest than call open interest) in F&O.
If the F&O market is speculative, the market signals may be positively correlated. Both markets may be oversold or overbought at the same time.
If there are effective arbitrageurs, the differentials between spot and futures prices should be low. Volume action should rise markedly in the last few sessions before F&O settlement because that's when arbitrageurs will be most active.
In practice, trades are constrained because the spot market is delivery-based. This makes market-neutral strategies where a trader goes short in spot, collects cash and parks it in a negative-correlated derivative difficult.
In order to be short in spot, you must give delivery with stock borrowed at negotiated rates. It's usually not worth the bother. Hence, we are unlikely to see a combination of short-spot & long F&O attitudes.
Another point related to market-structure is worth noting. Hedgers prefer options to futures. The downside in an options position is limited and asymmetric. The downside in a futures position is symmetrical. So a futures position is not a great hedge. Speculators prefer futures - the upside is more on a small move. If there are a lot of hedgers, we'd expect a cluster of options close-to-money in 'hot' stocks as well as in the indices.
When we looked at the data with these thoughts in mind, here's what we found:
In Stock F&Os, Speculators Rule
Volumes in futures are far more than volumes in options. Please note that volumes are reported differently in futures and options. A single Nifty futures contract is reported as Rs 369,000 (minimum contract value if the near-term Nifty is at 3,690) while options positions are reported according to the formula of premium X minimum lot - that is, Rs 5,500 for a Nifty 3,700 Call (3700CE) priced at Rs 55. Therefore Rs 3.7 lakh and Rs 5,500 are actually near-equivalent exposures.
Instead of seeking to find appropriate multipliers for options positions to equate contract values with futures positions, we can simply look at the number of contracts instead.
Futures positions far outweigh options in stocks. By rupee value, stock options constitute just 5% of total stock F&O trades. In terms of number of contracts, stock futures contracts outnumber stock options contracts by almost seven times. This makes it a strong presumption that there aren't many stock-specific hedgers. When people trade stocks, they do it naked or they hedge via the index. Over 60% of the volumes in stocks futures are generated by retail traders - who tend to be naked speculators.
In Nifty, Hedgers Are Present in Force
Options are used by more sophisticated players. The Top 25 members of the NSE generate over 60 per cent of options volume. The number of Nifty options contract is roughly the same as the number of Nifty index futures. In some months (June and Aug) there were more options than futures.
When we look deeper, the index signals also appear to be inversely-correlated, which reinforces our feeling that there's hedging in the Nifty. The market has moved up since mid-June when it hit a low of 2600. Nifty puts have consistently outnumbered Nifty calls through late-June, July and September and the Nifty put-call ratio has often risen above 1.5. This inverse correlation means significant hedging is taking place via the Nifty.
Stock put-call ratios are not inversely correlated. Stock put-call ratios have consistently been very low - in the region of 0.2 to 0.3. That further reinforces our feeling that stock F&O action is very speculative in nature.
Arbitrage Exists
Arbitrage does seem to be happening. Apart from FIIs, several arbitrage funds have entered the Indian market. Whenever profitable price differentials have occurred, these appear to be traded. By and large, differentials in spot and F&O are low. Arbitrages do exist and pop up close to settlement when volumes expand as we would expect.
Arbitrage action is also constrained by spot-delivery. A standard arbitrage trades differences between spot and future prices. The idea is to short the higher-priced series and go long in the lower-priced series. On settlement day, prices of both spot and futures must align. Then the reverse trades will lock-in the profit. If you can clear even 1 per cent arbitrage per settlement, it will annualise to a decent return.
Short spot, long future trades are impossible - borrowing stock is too expensive at thin differentials. Giving delivery and going into a long future is possible with the intention of buying back the stock. But the commonest arbitrage is to take delivery in spot and go short in futures. On settlement day, you reverse the paired trades.
If arbs are present in force, we may expect futures to rarely trade at large premiums to spot since this can be easily arbitraged. So we would expect low or negative cost of carry to be the rule if arbitrageurs generate effective volume.
Cost of carry is a good indication of arbitrage and CoC is another indicator where stocks and indices differ. Cost of carry on index futures has tended to negative except very close to settlement. But it's tended to be consistently positive throughout settlement in hot stocks. It seems that speculators going long on an optimistic “view” generate more volume than the arbitrageurs can handle. It's nice to know that there's money on the table to keep all those “arb-funds” in business.
What conclusions can be drawn from the above examination of data?
Well, we don't have enough data to draw strong conclusions. It's true that the patterns noted above have been fairly consistent through the past six months. But this could be a spurious pattern generated in a random burst - like a cricket captain winning (losing) several tosses in a row.
But our superficial examination does seems to suggest
The F&O market, especially the stock F&O segment is dominated by speculators
Hedgers concentrate on the Nifty
Arbitrageurs do operate but their actions are insufficient to balance speculators
Understanding this behaviour could be useful for an F&O trader - no matter if he's a hedger, speculator or arbitrageur.
(Data Source: Derivative Update September 2006, NSE)
