On August 24, the Nifty declined close to 5.92 per cent, making it one of the worst single-day declines in history. Such panic days are rather common in the equity markets.
However, that day, something unusual happened in the options markets. Here are some data points from that day. One, the Nifty declined 5.92 per cent or 490.95 points. Two, India VIX increased 64.36 per cent or 11.02 points. Three, the average increase in call options premiums (for strikes between 8,650 and 9,200) was 50-80 per cent.
Traders familiar with options would know that call option premiums decline when the market declines. In fact, most (strikes below 8,600) did decline in value but option strikes above 8,650 behaved differently — their premium as opposed to the general expectation did not decline, but rather increased. This move perplexed traders, and many attributed it to random theories such as rate rigging, market manipulation, technological inefficiency and liquidity issues. But this can be explained with the option theory logic.
Option premiums are influenced by sensitivity factors called Option Greeks. The delta of an option is an Option Greek (varies between 0 and 1) that captures the sensitivity of options premium with respect to the movement of the underlying. For example, if the delta of a particular call option is 0.75, then for every 1 point increase/decrease in the underlying the premium is expected to increase/decrease 0.75 points.
Low delta On August 24, the Nifty declined 490 points, so all call options which had ‘noticeable delta’ (like 0.2, 0.3, 0.6 etc) declined. Typically ‘in the money’ options (as on August 24, all strike below 8,600) tend to have noticeable delta, therefore all their premiums declined with the decline in the underlying.
However ‘out of the money’ options usually have very low delta — 0.1 or less. As on August 24, all options above 8,600 were ‘out of the money’ options with low delta values. Hence, irrespective of the massive fall in the market, these call options did not lose much premium value.
This explains why certain call options did not lose value; but why did the premiums go up? The answer to this is lies in vega — the Option Greek which captures the sensitivity of market volatility on options premiums.
Volatility and vega With increase in volatility, the vega of an option increases (irrespective of calls and puts), and this leads to increase in option premium. On August 24, the volatility of Indian markets shot up by 64 per cent. With the increase in volatility, the vega of all options increases, thereby their respective premiums also increased. The effect of vega is particularly high for ‘out of the money’ options.
So, on the one hand, the low delta value of ‘out of the money’ call options prevented the option premiums from declining while on the other hand, a high vega value increased the option premium for these ‘out of the money’ options.
Hence, on August 24, we got to witness the unusual — call option premium increasing 50-80 per cent on a day when the markets crashed by 5.92 per cent.
The writer is Vice-President, Zerodha Varsity