Volatility Informed Trading in the Options Market: Evidence from India

Abstract

The purpose of this paper is to investigate the trading activity in options market based on information about expected future volatility in spot market. We employ Common Implied Volatility as a measure of expected volatility and options volume and changes in Open Interests as measures of options trading activity. We first test for simultaneous information flow in the two markets using multiple regression technique. Next, we test for information based or hedge based use of options using Trivariate Vector-auto Regression framework. We further consider the classes of options moneyness and the market trends in our analysis to examine if the trader’s preference of options changes with change in description of options intrinsic value and market environment. We use daily closing data of S&P CNX Nifty Index options traded on National Stock Exchange, India. We, for the most part, find negative and significant relationship in contemporaneous regression suggesting active trading by arbitrageurs. A feedback relationship is observed in vector auto regression analysis suggesting that options are traded in India for both information based trading and hedging purposes. We also observe the relationship to be varying when market trends and classes of options moneyness are considered. This indicates that traders are not indifferent in their choice of trading venue when market conditions and factors change. The results of this study are helpful for traders in managing the risk and return of their portfolio based on volatility forecast. This study is distinctive as it examines the scarcely researched area of volatility informed trading in an emerging market set up.

Informational role of futures volume for spot volatility

“…However, the present study highlights the futures market as another market preferred by informed investors in addition to options market. Contemporaneous interaction between spot volatility and option volume is also supported by Pan and Poteshman (2006) and Sarwar (2005), along with Pathak (2015). The present study is consistent with their work.…”

“…The study does not support the theory that call and put options behave differently in the simultaneous equation model between spot volatility and option volume. There have been a few studies that contradict this and support the finding of the current paper (Ho et al, 2012;Pathak, 2015). The paper does not find moneyness categories to respond differently to the simultaneous relationship between spot volatility and option volume.…”

“…2.2 Contemporaneous interaction among spot volatility, futures volume and option volume Sarwar (2005) and Pathak (2015) investigate the contemporaneous interaction between spot volatility and option volume. Boonvorachote and Lakmas (2016) find a contemporaneous association between futures volume and spot volatility (results presented by Boonvorachote and Lakmas (2016) pertain to the commodities market).…”

“…To test the simultaneous equations between option volume and spot volatility, the latter is measured using both the IV method and the GARCH model (Pathak, 2015;Sarwar, 2005). The simultaneous equations mathematically describe the proposed conceptual model [equations ( 1) and ( 2)].…”