ET Intelligence Group: An event risk is typically a delight for derivatives traders who use market volatility to mint money. However, this time around they are finding it challenging to cash in on the expected volatility on May 23, the day when results of the general elections will be out. This is due to low liquidity and inability of option sellers (writers of the options) to compute probability adjusted premium, thereby blurring the price discovery process. As a result, cumulative outstanding open interest of options on the Nifty 50 index between 11,000 and 11,300 strike prices expiring on May 23 is just four lakh shares, according to data compiled from the NSE. The build-up is in sharp contrast to India VIX — a measure of fear among trader and expected volatility — which has reached 28.3 – a four-year high level.
The implied volatility of put and call option between the strikes of 11,000 and 11,300 shows that the market is expected to move 2-2.5 per cent in the near term. This is a reflection that market participants have not yet priced in a higher volatility in the days leading to May 23.
Option sellers rely on empirical or logical method to calculate probability-adjusted premium. For this, they need to first determine the probability of an event and that’s where the problem lies. They are unable to compute the probability of a BJP win.
If there is a higher likelihood that the BJP wins the mandate for the second five-year term in a row, the slide in the benchmark index will be lower. On the contrary, if the probability of a non-BJP government is higher, the market fall may be steep. Given the complicated nature of political coalition structures and a higher dependence of the outcome on swing votes in the large states of UP and West Bengal, traders are finding it difficult to calculate the probability of the possible election results.
Option sellers are subjected to the highest risk due to an unlimited loss in case of a bad judgement of probability. Portfolio managers are typically the buyers of put options in times of event risk and are willing to shell out a higher premium to hedge their portfolios.
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The situation may, however, improve once the exit poll numbers are out on May 19, according to a derivative trader ET spoke to. “Currently, derivative traders are finding it difficult to get reasonable price and quantity to initiate a new strategy. As a result, liquidity is quite low. Once the exit poll numbers are out, it will become easier to build in probability-adjusted premium, which may improve liquidity,” he said.
Another factor to watch is the clarity of the outcome. If any clarity on the election results fails to emerge before the end of the trading session on May 23, which is also the day of weekly expiry of contracts, due to delay in counting of votes, it will make volatility trades further unviable.
