High volatility during low VIX – Is it possible?

National Stock Exchange of India (NSE) is the world’s largest derivatives exchange by trading volume (contracts) as per the statistics maintained by Futures Industry Association (FIA) for calendar year 2023. It has held this position for the fifth consecutive year. It is evident that the meaty portion of the derivative volumes is from index options.

This data flies in the face of the SEBI study that showed that 90% of derivative traders lost money. The introduction of weekly index options has raised the engagement with markets like never before while, a combination of improvement in technology and internet speeds have ensured that traders are glued to their broker apps arguably as much, if not more than social media apps. While NSE’s Nifty and Bank Nifty were the sole indices in the derivative space for a long time, the competition between exchanges have led to a proliferation of indices. We now have Fin Nifty, Nifty Mid cap, Sensex, and Bankex, with Nifty Next being the most recent addition to the F&O space, having started trading on 24^th April, ensuring that we have atleast one index expiring on every day of the week, as opposed to just one expiry day per month, earlier. What is beyond argument is that there is indeed demand for these products, and there is enough supply as well. A change in landscape though is the extent of FII participation which has gone down across assets, domestic retail clients hogging the bulk, so much so that we no longer wait anxiously to get the day’s FII DII sales and purchase data. But despite the rise in domestic participation, FIIs are still an important force of reckoning that can not be ignored as FIIs’ action is more concentrated than that of domestic participants and thereby more likely to move markets. Gone are the days when SGX nifty used to be a trend setter for opening trades in Indian markets, but with trades shifting to Gift Nifty, the influence has considerably declined. But, the idea that a derivative instrument can be influenced by a proxy has become centre of discussion again recently. A Bloomberg report reported how “traders from America are strategically looting the Indian market. Two US traders, Douglas Schadewald and Daniel Spottiswood, formerly of the ‘Jane Street’ hedge fund, have been arrested for employing High-Frequency Trading (HFT) tactics tailored for Indian F&O markets.“ While the details flow in, let us look at if it is possible to form a nexus between positions in index options and constituent stocks.

Source: NSE, smart-investing.in

Well, theoretically, it seems to be the case, as you can see from the table above that among constituents of the four most actively traded index options, many of which contribute atleast two percentage weightage to the respective indices, are common in atleast two of them. For example, HDFC bank, Axis Bank and State Bank of India are in all the four indices, while Infosys, ICICI Bank and Kotak Mahindra Bank are in three of them, So theoretically atleast, a push to any or some of these stocks may be enough to create a large move in indices, and profitable set up can be created by taking prior position in index options. On the face of it, this also explains how large moves are seen in index options for brief periods, which are seemingly out of place with the low volatility signals given by VIX, a gauge of index volatility, being near record low.