My latest at Yahoo is about the Options Market, and volatility assumptions:

When the headlines go “Market volumes more than 100,000 crores!” it usually leaves you thinking that must be a good thing. But as much as volumes matter, what constitutes the volumes matters more. Trading in the ‘cash’ market – where stocks are bought and sold – has been largely unchanged since 2007. In July 2007, average daily volumes in stocks on the National Stock Exchange (NSE) were about 12,200 crores – which makes the average July 2010 trading volume of 12,600 crores horribly flat, even when nearly 300 more stocks were listed or traded in the interim.

The growth has largely been in derivatives, and there, in the options market. India has a very vibrant stock futures market, which some say is the biggest in the world. But stock and index futures have traded a daily average of 33,000 crores in July 2010 – much lower than the 40,000 crores in July 2007, three years ago.

So what’s really contributed to this “growth in volumes” that you hear about? Index options. Three years ago, a modest volume of Rs. 4200 crores per day has now become a 46,000 crores last month, a tenfold increase. Trading has dramatically increased in the index options market – specifically, the Nifty options market. One might wonder why these contracts trade heavily now, and why don’t stock options trade quite as much?

Nifty options are, for one thing, European contracts. (This doesn’t mean they carry serious risk or will demand lesser working hours and speak strange languages). Quick primer: A ‘call’ option is a contract that allows a holder the right, but not the obligation, to buy a stock at a certain ‘strike’ price expiring on a certain date. While that is a ‘call’ option, a ‘put’ option allows the holder to sell at the strike price. (More basics)

Now, European contracts only allow that to happen on the expiry date, not earlier. American contracts – which is what all the stock options (as opposed to Index options) are on the NSE – allow exercise on any day before the expiry date, which is the last Thursday of the month.

European option preference is a structural problem with our exchanges. Sellers of (American) stock options have the “risk of exercise”: at about 5 pm, you are notified that the option contract was exercised – leaving you with an open risk of price changes till the next morning. Someone who sold, for instance, a Reliance 1000 call and bought the Reliance stock to hedge, may be exercised today at Rs. 1020 – yet, he can’t act on the ‘hedge’, the Reliance shares, till tomorrow morning, when the stock may open at 1010 giving him a Rs. 10 loss with no control. In America such an ‘exercise’ would transfer shares from the seller to the buyer – but in India, options are cash settled. Index options – which are only exercised on the expiry date – have no such risk.

Another reason option volumes look enormous is the way options are accounted for. A single Nifty contract is displayed as a volume of about Rs. 2.5 lakhs (50 Nifty at the 5000+ value it is currently). The actual premium for the contract may only be Rs. 1000 (at Rs. 20 per Nifty). In effect what we see is just ‘notional’, with actual transaction amounts being a fraction smaller of the reported volume number.

The downside of having this much trading in the stock markets is that people make a lot of unhealthy assumptions about volatility. Heavy option trading has led our markets to forget the times of 2008 and 2009, it seems. The VIX – a volatility index based on option premiums – gives us an idea of what markets think about volatility. The VIX is now about 19, versus the historical average of 35. Option premiums indicate market expectations of just a 2% move in the benchmark index over the month of August, and markets as a whole have been very range-bound this year – in the seven months since the beginning of the year, we have seen markets move just 3 percent!

In the background, retail investors seem to be stagnant in terms of numbers. Sucheta Dalal says there may only be 40 lakh – 4 million – investors in the stock market, gleaning from the 1.7 crore demat accounts in the country and dividing by four to remove duplicates. Mutual funds have lost 8,000 crores in equity fund assets, on the back of a rising market. It also seems that lower trading volumes have affected brokerage stocks, which have ?underperformed the rising market.

The apparent lack of volatility and that volumes aren’t really improving are a worry, especially since indices are scaling new 52 week highs, or indeed, two year highs. On the other hand, such factors should almost definitely result in a fall in the market, and a number of participants have been expecting such a slide that just hasn’t happened. They are often quoted as evidence of market support; “Money is on the sidelines” is mentioned as a defense of a thin market. But I remember them saying that in all of 2008 when the money stayed in the sidelines as the index fell 50%.

There’s hardly any point predicting the future of stock prices – you need to walk over the graves of those who tried – but to many who extrapolate the future using historical prices, the lack of volume and volatility is a danger sign. Using current metrics, one may be tempted to take on massive risks, betting that the indices won’t move too much and swallowing as much option premium as possible. But that is like picking coins in front of a roadroller; the upside is very tiny, and the downside is extremely unattractive.

More basics: Derivatives on the NSE trade in “lots” – a contract is usually a fixed number of shares, like a Nifty contract is equal to 50 times the Nifty value. Similarly, Reliance shares currently have a lot size of 250. Indian derivative lot sizes are different for each stock or Index, and are modified regularly to reflect a market value of around Rs. 2 lakhs per contract.

A holder of an August Nifty 5400 call contract gets the right to buy 50 Nifty at 5400 at the end of the August cycle. If the Nifty is at 5500 then, he would ‘exercise’ the option, taking a profit of Rs. 5000 (Rs. 100 each for 50 Nifty). Below 5400 he can choose not to exercise the option and let it expire worthless. What he loses then is only the “premium” paid upfront for the contract. So if the 5400 call cost the buyer Rs. 60 per Nifty in premium, his real profit at 5500 is actually Rs. 40.

Exercising isn’t the only way to make a profit on the option – the premium may have gone up from Rs. 60 to Rs. 80, and you can sell the options and get the Rs. 20 benefit. Considering most options expire worthless, there is a substantial amount of profit to be made in selling, or “writing” options as well. Unlike the buyer, a seller has an obligation to deliver on the contract if required – so a seller of the 5400 Nifty call has to sell Nifty at 5400, even if Nifty is at 5600 at expiry.

Options are useful risk management tools, in combination with each other or with the “underlying” stocks or indices. I could, for instance, buy a 5400 call and sell a 5500 call at the same time, creating a call “spread” which gives me a benefit only between 5400 and 5500, a structure not possible by doing purely stock or futures trading.

Read a more detailed tutorial on futures and options.

Now, tell them about it: