Anyone who watches the market closely knows that some days feel different. Prices swing faster, volumes surge, and commentators speak of expiry. The BSE Sensex is among the benchmarks on which futures and options contracts are based, and these contracts shape trading behaviour in subtle ways. Products linked to several BSE Indices also settle on specific dates, adding to the activity. For investors who do not trade derivatives, understanding expiry helps explain unusual movements and avoid unnecessary worry.
What Futures and Options Are
A derivative is a contract whose value is derived from an underlying asset, in this case, a market benchmark. A futures contract requires a buyer and seller to transact at a fixed level on a future date, while an options contract gives the buyer the right, but not the obligation, to buy or sell at a predetermined level in exchange for the premium paid upfront.
These instruments are used by participants for different purposes. Hedgers use them to hedge their portfolios against downside risk, speculators take positions in these instruments to make profits from price movements, while arbitrageurs exploit price differences in different markets. The price differences are eliminated because of the activities of arbitrageurs, leading to price discovery
Why Expiry Days Are Special
Derivative contracts have specific expiry days on which the open positions are settled either through cash or delivery. Because of the need to settle positions on the expiry day, there are always high volumes of trading as traders close their positions. Index contracts are cash settled, which means that there is no delivery of shares. On expiry day, the value of the index is determined by the closing level and formulas published by the exchanges and this stimulates trading volumes on the expiry day as traders close their positions
Rolling Over and Open Interest
Traders who are bullish or bearish beyond the expiry date roll over their positions by closing the expiring contracts and opening new positions on a future date. It is always possible to determine the volume of trading on any given day by the open interest position. Generally, rising open interest and prices signify new long positions being opened by traders and are therefore positive for the prices of the shares. On the other hand, a fall in open interest and rising prices indicate new short positions which are negative for the share prices. On expiry day, the open interest falls as traders close their positions and this provides an insight into the market psychology at a given time.
Effect on Ordinary Investors
Expiry day volatility does not affect ordinary investors who buy shares through mutual funds and hold onto their positions for a long time. Volatility which manifests itself in intraday movements is not sufficient to influence the value of fundamentally sound stocks. Ordinary investors should therefore ignore expiry day volatility as it is usually a short-term phenomenon, and the best thing to do is to hold on to the shares for a long time.
However, for active traders who trade their own money, expiry day volatility should be a pointer of the general market psychology. Traders should only use small percentages of their trading account when placing trades and should cut their losses short while letting their profits run. They should also set stop-loss orders to prevent losses from becoming too big. One should never use savings money or take loans to trade derivatives because losses are likely to outweigh gains, and a lot of individual investors in India are perennial losers in derivatives trading, as shown by empirical studies by the regulator.
Safe Practices for Those Who Participate
Traders should understand the products they are trading. They should start small, use stop-loss orders, have good margins and not use leverage. Money saved for a specific purpose should not be used when trading derivatives. Trading should begin with small positions, and stop-loss limits should be set.
Traders should avoid unlimited risk strategies and set targets. Keeping records of derivative transactions is important for tax purposes because the income arising from them is taxed as business income, and the records are useful in determining the tax liability.
Staying Informed About Rules
Regulators are always reviewing trading strategies and guidelines for derivative contracts, and it is important to read and understand them. One should always read notices sent by the clearing agencies and brokerages regarding expiry dates and limits, among other things. Understanding derivatives and the underlying assets makes one a good market observer.