Expiration day effect on stock pinning and market volatility

Abstract

Introduction of financial derivatives is considered as one of the most important developments in the Indian financial market. The activity in derivative market has increased manifold over last few years. While these derivative contracts have significantly contributed in financial modernization, these also come with a risk of potential market manipulation in the underlying market. The primary focus of this paper is on investigating the expiry date effect of the derivative contracts on the underlying market. The paper has two parts. The first part analyzes the effect of expiry date on market volatility and the second part focuses on a specific market manipulation technique called stock pinning. On and around the expiry date of derivative contracts, the trade volume and price volatility could be higher compared to non-expiry dates. The theoretical reason for it can be explained in terms of arbitrage opportunity due to price imperfection in the future market, price manipulation by the large broker houses and stock pinning. This paper analyses the trading volume, closing price, return and volatility of NIFTY index during the expiry of NIFTY derivative contracts. The analysis was done over a period of five years starting from 2006. Three techniques were used for analysing the effect. The first technique was data masking where the actual data on the expiry week was masked with figures calculated using trend setting equations. This data was then compared with the actual unmasked dataset to see if the presence of expiry week in the dataset changes the central tendencies significantly. The only conclusion that was drawn from this analysis was trading volume during the expiry date is significantly higher. Subsequent analyses were done by splitting the entire dataset into sub-samples for expiry dates, non-expiry dates, expiry weeks and non-expiry weeks. This analysis also showed higher return during the expiry week along with higher trading volume. No conclusion could be made for volatility and price though using this method. Finally, the sub-samples were further divided based on the year. Same analysis was done on each individual year. This analysis also showed significant higher volatility in the underlying market on the expiry date. The analysis done on the data from 2006 and 2010 empirically shows higher trading volume, price return and price volatility on the expiry dates vis-a-vis non-expiry dates for NIFTY index. This analysis could further be extended for individual stocks. As the price manipulation for individual stocks is expected to be much easier, similar effects may exist. The analysis can yield better conclusion if the historical intra-day data for the underlying is available. The second part of the paper dealt with a phenomenon called Stock Pinning where the stocks on which options are available tend to close at strike price on expiration date. Stock is pinned “if the closing price of the stock is within 5% of the Strike Interval”. Strike interval is defined as “difference between strike prices of two consecutive options”. There are various reasons for which such a phenomenon is observed. Rebalancing of portfolio by delta neutral investor, propriety position by broking firms and max pain theory are few of them. In order to see if such a phenomenon exists in Indian market, we identified suspect set (optionable stocks) and control set (Non optionable stocks). For each stock in both the sets, we identified the occasion when the stock was pinned during last five years. For control set, we assumed that options exist and did similar analysis. It was found that with 81.4% confidence interval, we can conclude that there was difference between suspect set and control set which indicates that stock pinning exists. Second analysis was temporal analysis on stocks of suspect set. With historical data of preoptions period and post option period, we found how many times they are pinned in post option period and how many times they would have been pinned in case options were available in pre-option period. We observe that with 91.4% confidence interval, we can conclude the post option period has more pinning occasion than pre-option period. We also observed that even if stocks were not pinned, there is a tendency to approach the strike price on expiration day. Intraday observations on expiration day shows that in suspect set there was movement observed towards strike price on expiry date towards the close but no such movement exist in control set. Max pain is the price of the underlying at which investors will book heavy loss or make minimal profit. Max pain analysis on stocks which were pinned the most indicates that though stock pinning is there in Indian market but no max pain phenomenon exist in Indian market. The analysis can be taken further by identifying how strong different parameters are in Indian market. Regression of pinning occasion against the parameter representing delta neutral impact, impact of propriety trading will help us identify their strength and if any other parameter exists in Indian market.