India's Equity Options Market – a Giant too hard to tame?

Unexplained wild short lived price swings on option expiries and underlying cash market don't bode well for broader market development. (For those well versed with India's options market and ODTE please jump to the section on Potential Risk loopholes)

India's ever booming equity options market can easily be touted as the third obsession of the country in addition to Bollywood and Cricket. Indian exchanges have facilitated the highest options contracts volume in the world since 2019 with National Stock Exchange bearing the crown for the largest derivatives exchange by far in terms of futures and options contracts traded.

Chart 1 – India boasts of the largest option contract volumes in the world

Each passing year however the crown gets heavier and likely harder to manage as the burgeoning derivative volumes have dwarfed cash markets volumes to potentially create an ecosystem rife for manipulation in the guise of speculation. Before we get into the specifics of potential risk vulnerabilities, let's understand the market structure:

1. The daily average volumes of the equity options market surely need to be quantified to get a sense of the size of the giant. In the month of March 2024, little over 10.5 billion equity option contracts were traded on both exchanges with NSE accounting for ~81% of the share. For a like to like comparison with the cash market let's consider the traded notional – monthly notional equity derivatives turnover for National Stock Exchange in March 2024 stood at INR 7218 trio or ~USD 87 trio! Note that this is the cumulative monthly notional computed as number of units of the underlying per contract multiplied by the value of the underlying, i.e. it accounts for the changing market value of the underlying.

Chart 2 – Trends in Average Daily Notional turnover in Equity options on exchanges (figures are in INR crore, 100 crore = 1 bio)

The chart above quotes average daily equity options notional traded on both the exchanges – for the 19 business days in March 2024, NSE recorded daily notional turnover of ~INR 380 trio or USD 4.58 trio while BSE recorded at ~INR 80 trio or USD 0.96 trio.

2. Corresponding figures for the cash equity market are on a significantly smaller scale. NSE's cumulative cash equity volumes in March stood at a miniscule INR 20.43 trio or USD 246 bio. Similarly, against BSE's monthly equity option notional turnover of INR 1519 trio or USD 18.3 trio, its monthly cash turnover stood at INR 2.76 trio or USD 33.25 bio. That's an options to cash volume ratio (summing up both exchanges) of 377x!

Chart 3 – Trends in Average Daily turnover in Equity Cash segment on exchanges (figures are in INR crore, 100 crore = 1 bio)

Here is a cross-country comparison of the derivatives (futures and options) to cash volumes ratio, apologies the chart is a bit dated (ending H2 2023) but the difference would be just as stark if not more as of today:

Chart 4 – Derivatives to Cash Volume ratio across countries

3. Market participants' share in the overall turnover on both exchanges is also noteworthy – domestic prop traders in formats like algo funds, hedge funds, high frequency traders et al. are the biggest presence in the options market closely followed by regular retail and high networth individuals – summing up to ~73% participation. While the prop community can be assumed to be savvy with the derivative product, the same can't be assumed for retail and HNIs especially those with non-finance background.

Cash equities interestingly have the same percentage of prop + others participation but the definition of 'others' is much wider to include partnership firms, AIFs, PMS clients, non-bank finance companies etc. to represent a more market savvy/risk-aware pool of investors relative to the options market.

Table 1 – Market Participants' share in equity derivatives across exchanges

Others category comprises of retail and high networth individuals. Source: SEBI Annual report FY22-23

Table 2 – Market Participants' share in cash equity across exchanges

*Domestic Institutions (excluding Mutual Funds) include banks, Domestic financial institutions, Insurance companies and the New Pension Scheme. **Others include individual domestic investors, Partnership Firms/LLP, Trust Society, AIFs, Depository Receipts, PMS clients, Statutory Bodies, VCFs, NBFC etc. Source: SEBI Annual Report FY2022-23

SEBI conducted a study on the individual traders' profit and loss in the Equity F&O segment for financial years 2019 and 2022. The report is surely worth a read to understand the nature and degree of involvement of the average Indian retail across ages and cities in the equities derivatives product. For good order individual trader/investor includes HUF (Hindu undivided family) and Non-resident Indians and excludes prop traders, institutions, partnership firms etc. Here's a quick summary:

Table 3 – PnL comparison FY19 vs FY22

Source: SEBI, Pandemonium

1. Total number of unique individual traders in this market segment stood at 4.52 mio in FY22, that's a jump of over 500% versus FY19 at 710k. 88% of such individual traders were considered 'active' i.e. traded more than 5 times a year.
2. 9 out of 10 of these traders incurred losses amounting to an average of INR 110k or USD 1476 in FY22, with active traders losing a higher average of INR 125k or USD 1678. That compares with India's per capita income of USD 2300 in the same year!
3. 98% of this individual trader pool traded in options while 11% traded in futures in FY22, which compares with 89% and 43% respectively in FY19.

Contract specifications

Since NSE accounts for the lion's share of options activity (99% of equity derivatives turnover in FY23), let's consider the product suite below (product list isn't exhaustive).

• Minimum notional for an option contract was increased from INR 200,000 in July 2015 to INR 500,000 with lot sizes on any trading day adjusted for the value of the underlying to contain notional exposure between INR 500,000 to 1000,000. The intent here was to weed out reckless risk-taking (as much as possible) but in hindsight of course it pales in comparison to the explosion in retail activity.
• In terms of active trading the first 4 option products account for most of the volume. Nearly 98% of NSE's derivatives activity is in Index options with NIFTY 50, Bank NIFTY and Financial Services NIFTY accounting for 36.5%, 56.4% and 7.1% respectively of the total index activity as of FY22-23.
• During FY22-23 – Weekly expiries accounted for 76.3% of total index option turnover on NSE while near month (one-month expiry) accounted for 23.5%. And the percentages may be even more skewed towards weekly expiries as we speak.
• With over 45000 individual futures and options contracts spanning across indices and stocks, there's an expiry on every day of the week (Sensex expiry on Friday). If you add BSE's Bankex (expiry on Monday) to the list, there's a significant overlap of Banking and financial services heavy indices expiring on first three days of the week. In other words, even without a formal introduction of 'zero days to expiry' (0DTE) options, there's a buffet of such options to facilitate speculative play every day of the week.

Table 4 – NSE Equity Option Product suite and specifications

Above mentioned figures are the minimum notional at the time of introduction. The permitted lot size for futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time. Source: National Stock Exchange, Pandemonium

Refresher on Zero day to expiry (0DTE) options

These are options that expire within 24 hours or at the end of the current trading day, having decayed almost fully as they approach expiry and hence those without intrinsic value are very cheap to buy. But it's important to remember that options closer to at the money and approaching expiry are also closer to their peak gamma i.e. option value is extremely sensitive to the slightest move in the underlying's price. In case needed you can refer to option greeks in Pandemonium's options and strategies section for a refresher. Sudden spikes or troughs in the cash price of the underlying can result in exponential gains for those who have built a long gamma exposure. Here is why traders would engage in these options:

1. 0DTE permit very short-dated hedges to position for key market-moving events, allow for greater flexibility in managing higher frequency trading books
2. Since these are same day expiry options having lost nearly all their time value, are cheap to buy/need minimal capital deployment. In other words, they offer much higher leverage to option holders for the same notional exposure on the underlying.
3. Are very liquid i.e. in addition to being cheap, they get quoted in a tight bid-offer adding (for whatever it's worth) to their cost effectiveness to speculate on a single day's volatility of the underlying.

Recent onshore anecdotal evidence/research suggests largely speculative trading activity from retail in equity options with 'average holding period of less than 30 mins'. Expiry day volumes across the more actively traded indices (Nifty 50, Bank Nifty, Fin Nifty, Sensex) are all well above 50% of the total week's volume suggesting the craze for ODTE. Another way of validating this is to note that end of day open interest is a much smaller fraction, sometimes low single digit percentage of the day trading volume.

Potential Risk Loopholes

Now keeping this market construct as our backdrop, let's think of scenarios that can potentially expose the risk vulnerabilities of certain segments of the market. Severely deficient cash market liquidity versus options liquidity can create incentives for disproportionately high pay-offs at the cost of temporary disorderly market moves.

1. An intended block purchase of a certain index or stock in the cash market if preceded by the purchase of ODTE near 'at the money' calls on the index or stock can exponentially profit the option bet. This is because the block purchase in shallow cash markets may be enough to move the underlying's price (even if marginally) higher and accelerate the long gamma-powered gains in the ODTE option. Sizeable exposure to the underlying amounting to multiples of the notional cash purchase can be had with minimal capital outlay, in other words higher leverage of ODTE.
2. In the same manner an intended sale of a certain index or stock in the cash market if preceded by the purchase of ODTE near 'at the money' puts on the index or stock can exponentially profit the puts.
3. Option writers bracing for a peaceful expiry end up losing big in both cases, still worse in an otherwise trigger-less local and global market backdrop.
4. Wild swings in ODTE options and the underlying's price in the cash market has become more than an occasional occurrence. As an example, the Bank Nifty expiry on April 30th (brought forward by a day since original expiry on May 1st was a holiday) was a case in point.

Below is a Bloomberg snapshot of the intra-day price action – closer to 2 pm IST in a span of less than two hours the Bank Nifty Index first jumps 1% in the first 30 mins and then tanks about 1.4% from that peak in the next hour or so – that's a full range of nearly 1200 index points up and down on effectively no news.

Chart 5 – Expiry day NSE Bank Nifty Intra-day price action

Source: Bloomberg, Pandemonium

Intra-day price action in the corresponding ODTE European Calls and Puts (sourced from NSE's end of day Bhav Copy for April 30th) with near at the money strikes also shows a similar pattern within a similar time window. For instance, the call option prices near ATM/slightly OTM strikes shot up from 500-2500% (depending on their moneyness) as against a 1% upmove in the underlying in a span of 30 mins. On the down-move thereafter with expiry still closer, the put option prices near ATM/slightly OTM strikes jumped ~1000-10,000% (depending on their moneyness) as against a 1.4% decline in the underlying, in less than 60 mins! At the cost of repeating myself – liquidity is highest for ATM and closer strikes and so is the option's gamma to realise exponential gains. Alongside option sellers astounded by an exploding gamma-hedging bill for these strikes struggle to exit their positions at the eleventh hour crystalising huge losses.

Table 5 – Snapshot of NSE's Bhav Copy as of April 30, 2024

Source: NSE, Pandemonium

5. Interestingly these kinds of incentives in theory are also open to offshore investors who can accumulate the ODTE leverage via buying call or put spreads i.e. buying an at the money strike and selling another deep out of the money strike for equal notionals but with adequate net delta coming from ATM strike. As per the exposure guidelines of SEBI, net exposure on this option spread calculated as the sum of the same positive and negative notionals would be zero, making no impact to their outstanding option positions.

The sheer enormity of the equity derivatives market would make it challenging to track for disorderly price action especially sometimes in the presence of several moving parts both locally and globally. But to sustain a healthy operation and vibrance of these markets it may be worth observing some of these price movements with a fine tooth comb. SEBI and the exchanges have so far been proactive and amazingly enterprising in the development of the derivatives product addressing potential risks as and when necessary. I'm sure there's no reason for us to doubt that spirit going forward.