Last week, we discussed the likely impact of the SEBI directive to increase contract value of derivatives effective November 20. This week, we discuss another measure taken by SEBI: stock exchanges can offer weekly options on one index only. In response to this SEBI directive, the NSE recently announced that it will offer weekly options on Nifty Index and discontinue weekly options on Bank Nifty and other indices. We discuss the likely impact of this change on trading weekly options.

Focused trading?

Individuals typically trade multiple indices. From an individual’s perspective, this behaviour can be argued as a way of diversifying risk. If one index declines, the other may still go up and generate gains. On a broader perspective, taking exposure to multiple indices spreads the total demand and trading capital across strikes on these indices.

Now, assume that the total trading capital in weekly index options does not change. But now the exchange offers weekly options on the Nifty Index only. It is logical to expect traders to shift their focus to the Nifty Index, thus, increasing the demand for these contracts. More trading of the Nifty weekly contracts will improve price efficiency of the at-the-money (ATM) and the immediate three out-of-the-money (OTM) strikes. This could result in narrower bid-ask spread on these strikes.

But there is another issue to consider. While the focus could well shift to the Nifty Index, SEBI’s decision to also increase the contract value could act as a deterrent for retail traders. This could result in many such traders moving out of derivatives, even if temporarily. That said, SEBI’s decision to allow weekly options on only one index augurs well for traders.

Importantly, long-only traders could benefit. Why? Note that an option price consists of two components -- intrinsic value and time value. Time value is a residual factor whose value rises when demand for a particular strike increases. But time value must become zero at expiry. This means time decays rapidly as an option approaches expiry. When trading in weekly options is focused on the Nifty Index, demand (and volume) is likely to be higher. Importantly, tradable strikes will have better capacity to absorb any increase in demand. That is, bid-ask spreads may not widen much when demand suddenly increases. Logically then, long-only traders could benefit as they may not pay a large amount for time value when demand sharply increases, compared to the present.

Optional reading

The aforementioned argument rests on the premise that traders will want to trade weekly options more than they want to trade options on a specific underlying index. So, when NSE discontinues weekly options on Bank Nifty, it is highly likely that significant volumes could shift to Nifty weekly options rather than to the near-month Bank Nifty options. Also, even if there were a decline in volumes after the revised contract value takes effect, focused trading could improve price efficiency of the Nifty weekly strikes.

The author offers training programmes for individuals to manage their personal investments

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