Futures and options (F&O) trading volumes plunged in the first week of the Securities and Exchange Board of India’s (Sebi) new closing price discovery mechanism, as thin participation in the closing auction weighed on activity in the derivatives market.
The new mechanism, which replaces the half hour volume-weighted average price used to determine closing prices for 208 stocks available for derivatives trading, is still finding its feet. Market participants attributed the drop to initial uncertainty around the closing auction session (CAS), but expect volumes to improve as more investors and traders participate.
Volume fall
Average traded volumes of index futures, Nifty and Bank Nifty, fell 40% to 69,982 contracts in the week through 7 August, from 134,754 contracts in the week ended 31 July. Throughout last month, weekly average traded volumes ranged between a low of 95,433 contracts and a high of 141,912 contracts, per National Stock Exchange (NSE) data.
The story for weekly index options, expiring every Tuesday, was not too different. Volumes of index call options purchased on 4 August were at 151.9 million contracts, down 16% from 180.6 million traded on 28 July. Purchased put options volumes were down 10% last Tuesday from the one in the preceding week.
On the other Tuesdays last month, expiry volumes of calls purchased were between 167.13 million and 183.2 million contracts, per the data. Those of puts were between 164 million and 207 million contracts.
NSE had a market share of 99.7% in equity futures and 69.4% in equity options as of 30 June, per the latest exchange data.
F&O, a liquidity lifeline
Futures and options prices are derived from the spot or cash market prices. A derivatives price is the investor or trader's view today of what the spot price of a stock or index should be, say a month later. These instruments make the overall market liquid and reduce the impact cost, or the cost incurred to buy and sell a security.
A futures price based on large cash volumes tends to be more efficient as it is more broadbased than one derived from thin volumes with lower participation as seen during the first week under CAS.
For instance, combined NSE and BSE auction value during the first day (3 August) was at just ₹1,287 crore, against ₹5,000-6,000 crore during the last 15 minutes of trading under the old system , according to a qualified stock broker official.
Why the dip
Prevailing uncertainty over what prices could be at the auction closing has limited participation to passive funds, domestic and foreign high frequency traders and other foreign portfolio investors, even as arbitrage funds run by mutual funds and retail have largely kept away.
"Markets comprise a host of participants like active and passive mutual funds, arbitrageurs, retail investors, day traders, etc. The CAS is right now largely attracting passive funds, some FPIs and high frequency traders, but the extent of participation by arbitrageurs and retail is limited, right now which is why futures volumes are lower," said an MF executive requesting anonymity, given that CAS is a regulatory driven reform.
"We sincerely hope more participants will hop on to the CAS bandwagon as Sebi has asked brokers to go all-out on increasing participation of retail also in the new price discovery mode," he added.
Arbitrageurs exploit price mismatches between stocks and indexes traded in the spot and futures segments of an exchange, imparting liquidity to the market.
Volatile returns
The returns of the biggest arbitrage fund, which accounts for up 21.7% of the total arbitrage fund assets, reflect the volatility of spreads or gaps between cash and futures , thanks to the low CAS volumes.
The annualized return of Kotak Arbitrage Fund as of derivatives expiry date of 28 July was 6.64% as against the benchmark (Nifty 50 arbitrage index) return of 7.25%.
On the first day of the CAS, the fund's annualized return was 7% against the benchmark's 7.75%. The benchmark index return is used for comparing the fund's returns.
Unlike the previous closing price calculation that was based on the 30 minute volume weighted average price of a stock or index, the auction system is based on a single price at which maximum pooled orders for a stock happen between 3.20 pm and 3.30 pm. The auction orders are placed in a plus/minus 3% range around a volume weighted reference price derived during 3.00-3.15 pm.
This means the continuous cash market trading session closes 15 minutes earlier at 3.15 pm, while derivatives trading continues through 3.40 pm , creating uncertainty of spreads between cash and futures as the arbitrageur has to initiate buy cash and sell futures legs or vice versa in the case of reverse arbitrage simultaneously . The auction runs from 3.15 pm to 3.30 pm and a closing price for stocks and index is disseminated at 3.35 pm, basis which futures and options are settled.
Another mutual fund manager explained that for an arbitrageur to participate, the trader must get a profitable spread between cash and futures or vice-versa. The trader is not interested in a single price at which maximum executions of buy and sell orders happen under CAS. Being uncertain about the price at closing under CAS, and therefore the fund returns, he closes out most of his positions at 3.15 pm.
"Retail investors will have to adapt to the new system over time once the brokers' online trading applications are updated to prominently display the indicative closing price and the actual close," said Amit Golia, managing director and chief executive at Shriram Financial Services Pvt Ltd.