Volatility trading strategies and developing a volatility market in India

Abstract

While long-term equity prices are driven almost exclusively by core fundamentals such as earnings and valuation, short-term prices are subject to the fickle whims of investor psychology. Greed and fear have infinitely more influence on short-term market action than the strategic fundamentals that truly matter. Greed and fear, while equally powerful emotions, are asymmetrical in the way they influence market behavior. Greed develops and festers slowly, over many months or years, as one investor at a time gradually realizes that someone out there is getting rich in the markets so heor she decides that there is no reason why they can t do the same. Greed takes a long time to wax ecstatic and come to a boiling point among a large population of investors. Fear, on the other hand, often strikes the whole herd of investors at once out of the blue like a bolt of lightning. Some unforeseen bad news explodes onto the scene, or prices drop rapidly, and, like a flock of sheep, the chilling specter of fear leads to sudden mass selling movements. There is not often a long gestation period for naked fear, it can rear up rather quickly. It is this dark fear welling up deep within investors and speculators hearts that leads to volatility extremes, huge spikes in volatility accurately flagging interim selling climaxes.It is this volatility that is the focal point of our paper. Investing in volatility is attractive for investors seeking risk diversification and alpha generation. Often perceived as a negative representing uncertainty and risk, volatility can be potentially very rewarding if traders short on the peaks and buy on the lows. Volatility as an asset class is attractive because of its highly negative correlation with the stock market. Apart from that volatility as an asset class gives tremendous flexibility to the market participants as it allows even those investors to participate in the market who do not have any directional view on the market. The paper is divided into three modules. The first module discusses various volatility trading instruments that are available in the market. We discuss volatility trading via delta neutral option positions along with pure volatility instruments such as Volatility swaps and Variance Swaps. Next section deals with trading strategies using volatility as an asset class. It talks about number of strategies including straddles, dispersion trades, index spread trades and calendar spread trades. This section essentially looks at the past patterns to device a trading strategy. In the next module, we have tried to study the possibility of developing a volatility market in India. The module starts with a discussion on the importance of a volatility trading market fora country like India. With the increasing openness and correlation of emerging economies like India with the rest of the world, the domestic markets have become more volatile. While this is a cause for concern for risk-averse investors and traders, it s also an opportunity for speculators to make money riding on the erratic movements of the market. Opening up a volatility market in India would suit both the classes of investors. It would provide hedging opportunities to investors seeking to play safe and would protect them from unlimited downside risk. We have traced the liquidity in options market as one of the pre-requisites for a successful volatility market in any country. Further, we have compared the liquidity in US options market with that in India. The daily turnover in US options market (in terms of number of contracts) comes to approx 15 times that in India. We have then identified all the major factors affecting the liquidity in any options market. Having done that, we have analyzed the Indian market and identified the positive factors which would support the setting up of a volatility market in India. An exponential growth in Indian markets in the Futures and Options segment over the last 8 years, increasing awareness of the investors to volatility in BSE and NSE and willingness of SEBI to relax regulations to enhance liquidity are some of the positive signals in this direction. Last but not the least, we have identified the various points of concern which we need to keep in mind before going ahead with a volatility market in India. An improper execution or an incomplete planning can hamper the success of the proposed volatility market and can bring further instability in the equity markets. On the whole, India appears quite able to set up a volatility market. A comprehensive study of all the relevant issues would give us further insights in the field and would help in deciding the timeline for implementing the same.