Correlation Between Open Interest and Derivative Strategies and Optimize These Strategies: Empirical Evidence from Nifty Option Market

Correlation between open interest and Derivative Strategies and optimize these strategies: Empirical Evidence from Nifty Option Market

Introduction

An option is a type of derivative with contract between two parties – the buyer and the writer. In this contract the buyer has the right but not the obligation to buy or sell the underlying asset at a predetermined price known as strike price. For this option the buyer pays a premium to the writer of the contract known as option price. Options market is well known derivative in the world because it is more attractive than trading in the underlying assets because of following attractiveness as suggested by Black in 1975. It provides economic incentives by reducing the cost of transaction, reducing trade restrictions and also it reduces the capital required for trading purpose by providing margin. Option though was introduced as a hedging instrument it is also famously known for its speculation in the market. Just like any other market the attractiveness of this market can be determined by looking at the increasing trend in the total value of the trade in the option market over a period of time.

The question now arises is that, does the introduction of the option contract of an underlying asset in the market affect the prices of that asset. Cao in 1999 suggested that if the assumption of frictionless and competitive market is relaxed then the introduction of an option contract will affect the price of the underlying asset. From many other research it has been found that the not only the option prices affect the underlying assets prices but also the non price variables such as volume and open interest also affect the prices of the underlying assets.

We will be looking at some of the diverse literature on the interrelationship between the option market and the underlying cash market in the literature review section.

It has been proved by many researchers the role of open interest in determining the prices of the underlying cash asset which help analysts to predict the movement of the prices in future. Empirical research on Indian Equity Option Markey by Kedar nath Mukherjee and R. K. Mishra (2004) in determining the impact of open interest and volume in option market on underlying cash market confirms the significance of the open interest in predicting the spot price of underlying asset. This study will investigate the effect of open interest in predicting the Nifty50 index on a broader period and also investigate the impact of open interest on the most used derivatives trading strategies such as straddle, butterfly, etc prevailing in the market.

1.1 Brief Description of NSE and BSE

The stock exchange in India was first established in 1875 as "The Native Share & Stock Brokers' Association" which we now know it as Bombay Stock Exchange (BSE). Under the Securities Contract Regulation Act of 1956, BSE was the first stock exchange in India which had got the permanent recognition on 31st August 1957.It all started from meeting under banyan trees where all the interested party and brokers met in Mumbai near the Town hall. Though small in numbers the number of interested parties grew along with the trading platform and technology. With growing number of interested traders the exchange activity shifted to another bunch of banyan trees at the junction of Meadows street  Hence trading exchanges in India are appropriately described as from Banyan Tree to e-Trading. The wall street of India which is famously known as the Dalal Street or  D-Street was finally established as a permanent place for trading purposes in 1974. This marked to the formation of first Equity based Index of the country famously known as the S&P BSE SENSEX based on 30 shares, on 2 January 1986. The base year of the Index is taken as 1978-79 with the index value of 100 on 1st April 1979.

The top financial institutions where requested by the central government of India in the early 90s to form a new exchange which we know as the Nation Stock Exchange (NSE). Incorporated in 1992, NSE was the only exchange in India which was a tax paying company. It was in April 1993 that NSE was recognized as a stock-exchange of the country under the Securities Contracts (Regulation) Act, 1956. NSE started with the trading of Debt instruments in Wholesale Debt Market (WDM) segment in June 1994 and by November of the same year it also commenced operation of the Equities market in the country. The introduction of derivatives market was done in July 2000.

1.2 Futures & Options Segment in India

Equity-Derivatives trading took off in India in June 2000 following approval by the Securities and Exchange Board of India (SEBI) on the basis of recommendation of the LC Gupta Committee. The derivative segments of NSE and BSE were permitted to start trading and settlement in approved derivatives contracts with the involvement of their clearing house/corporations. Initially, SEBI approved trading in futures contracts based on different

Equity-indices, such as prominent ones like NSE’s S&P CNX Nifty and BSE’s Sensex. Later on, option- trading was permitted in indices as well as individual securities.

BSE started the first exchange-traded index-derivative in India on 9 June 2000. The

Inauguration of trading was done by Professor JR. Varma, Member of SEBI and Chairman of the committee that formulated the risk-containment measures for the derivative-market. Then followed a series of innovative-product launching: Sensex-Option 1 June 2001, Equity Options (on 31 stocks) on 9 July 2001, and Equity (or Single-Stock) Futures on 9 November 2002.

 NSE was not behind. It started futures on its popular flagship index, S&P CNX Nifty, on 12 June 2000. Trading in Nifty Options followed on 4 June 2001. It then went ahead with Equity Options (on individual securities); edging past its closest competitor, BSE, by only a week to became the first exchange in India to launch equity-option. Single-stock futures were introduced on 9 November 2001.

Literature Review

The diverse research over the past four decades on the inter linkage between the derivatives market and the cash market have incorporated many issues such as volatility of market, lead-lag effects, bid-ask spread, liquidity, expiration dates and also open interest of the contracts and volumes in cash market which are the most important parameters in our research. Following are some of the relevant and available research studies sorted as per the timeline.

Chicago Board of Exchange (The Chicago Board Options Exchange: The Birth of a new Market, working paper no.104) was the first to study in 1975 on the interrelationship between the cash market and the derivatives market. They took first four months of 1975 as their data. It was difficult to interpret the analysis as no test of significance was conducted.