How Some Traders Try To ‘Manage’ Nifty Bank
A lopsided banking index makes it possible for some investors to manage the weekly Nifty Bank options for quick returns on the day of expiry. All in the final 90 minutes of trade.
At the core of this strategy is HDFC Bank Ltd., which has a weight of more than a third on the Nifty Bank Index. A 1 percent (about Rs 20) move in the stock changes the banking gauge by 0.35 percent (nearly 100 points). This correlation is used to increase volatility and distort option premiums to make steep returns, according to market participants.
There are some sections of the market that indulge in this practice to make quick returns, Jitendra Panda, managing director and chief executive officer at Peerless Securities, told BloombergQuint. He explained how it’s done:
- Nifty Bank out-of-money call options—strike price higher than the market price—are bought a day prior to expiry; to hedge the positions, the next week’s put options are simultaneously purchased.
- In the last 30 minutes to one hour on the day of expiry, HDFC Bank’s shares are bought to drive up the Nifty Bank Index, increasing the volatility or risk.
- That causes the call option premium to witness huge upswing.
How It Works
A call option gives a holder the right, but not the obligation, to buy or sell an asset at a particular price—called strike—on maturity. Pricing or premium of an option is usually determined by the asset it’s based on, the strike price, the time value or the period remaining in the contract, and volatility or the risk involved. Option prices usually rise with volatility.
For out-of-the-money call options, since the strike price is higher than market price, there’s no chance of making a profit if held till maturity assuming the underlying asset doesn’t swing. Hence, the premium for these is lower. Such contracts are usually bought as a hedge to protect against extreme movements.
Moreover, the time value of an option erodes as it comes closer to the day of expiry. The value depletes at a much faster clip for an out-of-the-money option because the probability of it being profitable is even lower near expiry.
But when the underlying index swings on the last or expiry day of the contract, volatility spikes and increases the risk involved. As a result, the premium soars manifold. For some of the contracts of Nifty Bank weekly options BloombergQuint analysed based on the NSE data, the premium rose more than 2,400 percent in the last 90 minutes on the day of expiry.
The returns—subject to the securities transaction tax of 0.05 percent on the premium—are made by squaring off the positions with the exchange before the contract actually expires.
The National Stock Exchange declined to comment on BloombergQuint’s queries.
A person familiar with regulatory reporting, however, said all data related to trades is under constant surveillance and is shared with the market regulator SEBI at regular intervals.
HDFC Bank-Driven Volatile Days
The number of days when volatility spiked in the banking index on the day of expiry has risen in the last 14 months, BloombergQuint’s analysis revealed. Bank Nifty moved 200 points up or down on 21 Thursdays—or expiry day—since December 2017. That reflects higher volatility on 34 percent of expiry days, up from 17 percent (nine days) in calendar year 2017.
Most of the spike in volatility coincides with a jump in HDFC Bank stock price in the past 14 months. The lender swung over 1 percent for 33 days—more than half of the expiry days. On 21 of these occasions, Nifty Bank swung about 200 points in the last 90 minutes, causing a huge surge in option premium.
Why HDFC Bank Is Prone To Gyrations
The average daily volume of HDFC Bank were 25.52 lakh shares in the last 14 months compared to its more-liquid private peer ICICI Bank Ltd.’s 2.15 crore shares. Relatively low liquidity makes HDFC Bank shares prone to sudden change if any large trades take place.
People who have large positions in HDFC Bank are capable of affecting the price moves on the index, a head of derivatives at one of the bigger brokerages said. Since the only factor that affects option premiums on expiry day is the delta—or the rate of change in price of the underlying index—it leads to heavy moves in option prices, he said on the condition of anonymity as he can’t comment on trading strategies. That’s why there’s a discussion to cap the weight of a single stock to not more than 20 percent on the index.
Kotak Mahindra Bank, the third heavyweight on the bank index with 13.22 percent, also has low liquidity with an average daily volume of 25.42 lakh shares—almost equal to that of HDFC Bank. Both the lenders have a combined weight of nearly 50 percent on the bank index. Any sharp changes in the two will increase volatility of the bank index, and ultimately the related options.