There are several reasons why Nifty Index options are better to trade than equity options. This week, we discuss three such reasons — likelihood of capturing the upside potential, potential liquidity, and margin requirements.
Trading efficiency
The top 10 stocks in the Nifty Index contribute more than 50 per cent to the index weight. So, it is possible that even if the remaining stocks marginally decline, the heavyweight stocks can push the index up. This makes it relatively less difficult to capture the upside potential in the index compared with an individual stock. If you go long on a single-stock futures contract, the possibility that the trade will turn adverse is high. If you go long on Nifty Index futures, the index could move up even if some index constituents decline. Likewise, the chances of capturing gains trading Nifty options are greater compared with trading equity options.
Next, consider liquidity. At the time of writing this article, volumes on the Tata Motors 1100 call was nearly 50,000 contracts. In contrast, volumes on the Nifty 25000 call was 40 lakh. Though volumes are not a direct measure of liquidity, lower volumes could lead to weaker price support. By this, we mean a sudden adverse change in the underlying price may lead to sharp decline in the option price. This is because the adverse change will encourage option sellers to push the option price further down. And lower volumes mean there may not be enough buyers to strongly support the price at a lower level. Note this affects the option price through the option’s delta and theta. Delta refers to the change in the option price for a one-point change in the underlying. And theta refers to the loss in time value of an option with each passing day, all other factors remaining the same.
The final argument has to do with margin requirements. After the NSE moved from cash-settled settlement system to a delivery-based system, margin requirements on equity options have become an important variable in trading strategies. This is because margins increase during expiry week; holders of in-the-money (ITM) call options at expiry are required to take delivery of the underlying shares. That means traders must have enough money in their trading account to fund the purchase of the shares. Index options are cash-settled. So, the delivery margins do not apply to Nifty options.
Optional reading
The above argument is not meant to nudge you into trading Nifty options. Rather, it is meant to show that trading Nifty options offers a marginal edge over trading equity options. That said, if the underlying were to sharply move in the direction of your trade (breakout when you are long on calls), equity options are likely to offer greater upside potential than index options. Of course, if you are confident of a price breakout, long futures position, given its near one-to-one movement with the underlying, provides greater upside potential than long calls.
The author offers training programmes for individuals to manage their personal investments