Introduction
Derivatives are complex financial instruments characterized, in their simplest forms, as futures and options. Beyond their numerical valuation and technical definitions, derivatives are an integral part of understanding and shaping the behavior of the stock market each day.
Every major movement in the Nifty 50 or Sensex index has and will continue to be impacted by derivative positions. They do not respond to market sentiment; rather, they market manipulatively create and amplify sentiment. The stock price is determined by the constant friction between hedgers, speculators, and institutional market participants. This friction will determine the stock price volatility and stability.
This article seeks to explain the role of derivatives in the trading psychology underlying volatility, market behavior, and sentiment.
Exploring Understanding The Derivatives-Market Connection
Before understanding the market volatility, let us understand the connection between the derivatives and the underlying stock market.
There are futures contracts, which are commitments to buy or sell an asset at a defined time in the future.
There are options contracts, which grant you the right (but not the obligation) to buy or sell the asset at a defined time in the future.
When traders engage in derivatives, they communicate expected directional price changes in a market. These expected price changes affect liquidity, volatility, and sentiment, and they function such that a trader's market movement prediction determines the alignment of market sentiment and price changes.
Increased volatility is also driven by the thin margin requirements of derivatives. A trader's exposure to a derivative can significantly exceed the price movement of an underlying asset. A small market movement can have a magnified effect on an asset’s derivative position, which has a meaningful impact on an asset’s price volatility.
There are two sides to the relationship between derivatives and stock prices.
Market prices affect derivatives. In contrast, derivatives can affect the price movement of a stock or a group of stocks as a result of the price movement occurring in the future.
For example, if traders take a long position on index futures, stock purchases will increase. With an index position value of $1,000,000, the player will own stocks of a value of $1,200,000 on average. In contrast, a trader taking a short position will also take stocks of a value equal to the short position. Thus, this activity effectively forms a feedback loop by using stock derivatives.
Volatility: The Heartbeat of Derivatives
Volatility is defined as the measure of the magnitude and velocity of price movements. It is a measure of uncertainty and risk - the two defining elements of the price of a derivative.
There are two core forms of volatility:
Historical Volatility (HV): This is derived from prior movements in the price.
Implied Volatility (IV): This is derived from the price of the option itself and expresses the expected future volatility that a trader anticipates.
When option prices increases, it indicates that traders anticipate greater volatility. IV is widely considered an indicator of ‘fear and greed’ prevailing in the market.
In the Indian context, such sentiment is monitored and captured by the India VIX (Volatility Index), which assesses anticipated fluctuations in the Nifty over a period of 30 days based on option prices.
An increasing VIX is an indicator of fear.
A decreasing VIX indicates complacency and a positive market sentiment.
In this sense, derivatives - more specifically, options - are the truest representation of market sentiment.
The Impact of Derivative Activity on Volatility
1. Leverage Exacerbates Market Responses
The ability to use leverage is a core defining feature of derivatives. It allows traders to control large positions while putting up a small amount of capital.
For instance, a trader is able to purchase a Nifty futures contract valued at ₹10 lakh by just putting up a margin of ₹1 lakh.
When Nifty moves by 1%, a trader could realize a 10% gain or loss on their capital due to leverage. While this can be beneficial, it can also lead to increased short-term price volatility.
When a significant amount of traders in a market use leverage, shifts in market mood can trigger extreme volatility due to rapid increases in market orders or selling pressure in a very short amount of time.
Short sellers who buy back futures to close their positions can trigger a rapid increase in price, while sellers of cash instruments add to the pressure in the market. This can lead to price changes in the underlying instrument, distracting the market from the fundamental reasons to make those changes.
The last Thursday of the month is also associated with extreme volatility. This can be caused by the mass liquidation of positions as a result of a trader’s choice to roll over a position or to settle by expiry. Rebalancing of positions in the underlying instrument can lead to sharp price moves.
The market’s behavior, particularly around expiry time, is heavily influenced by the large near the money options open interest which can create price “magnitude” shifts. The position of the gamma also creates the volatility around options.
When market fluctuations become more extreme, market participants tend to over-adjust their positions and trade the underlying index more drastically in either direction.
This is referred to as “gamma hedging.” Depending on the magnitude of the loss, this strategy has the potential to either contain the volatility or make it worse.
For instance, extreme downturns tend to trigger aggressive option writer hedging, which has the potential to exacerbate market declines.
Sentiment: The Impulse Behind Price Changes
Like other markets, financial markets are affected by underlying human emotions and behavior, in addition to fundamental factors.
Derivatives market activity provides insight into market sentiments and changes in investor psychology, which may be quantitatively assessed using indicators such as open interest, volatility, and the put-call ratio.
1. Open Interest (OI)
An increase in OI and an increase in price suggest potential bullish sentiment as new long positions are being added.
An increase in OI and a decrease in market price suggest bearish sentiment, which is associated with the addition of new short positions.
A decrease in OI suggests the closure of positions, which is frequently associated with market trend fatigue.
2. Put-Call Ratio (PCR)
The ratio of put options to call options is one of the more recognized sentiment indicators.
A high put-call ratio (greater than one) suggests the purchase of more put options, which indicates a more pessimistic sentiment in the market.
A low put-call ratio (less than 0.7) indicates the purchase of more call options, which suggests an increased willingness to take risk.
Extreme values of the proprietary sentiment indicator (PCR)<i></i> can help predict market reversals. Therefore, the indicator helps evaluate the sentiment of the market participants.
3. Implied Volatility and Sentiment
As mentioned previously, uncertainty increases implied volatility.
During periods of market stress (e.g. geopolitical tensions, pre/post elections), investors 'flee the market' and buy put options. That sentiment increases demand for put options and increases IV. Thus, IV increases due to fear of losing money.
When investors' confidence returns, fear decreases and IV increases, suggesting return-to-risk.
Data from derivatives markets shows the mood of investors in a timelier manner than traditional indicators (e.g. earnings reports, GDP)
The Positive Contribution of Derivatives to Market Order
Derivatives may increase short-term volatility; However, they increase market Order in the long-run due to:
a. _Risk Transfer_: Investors are able to hedge instead of exiting a position. Therefore, panic selling is avoided.
b. _Liquidity Creation_: Higher volume of trade in the derivatives market promotes more orderly and efficient price discovery.
c. _Efficient Price Discovery_: Expectations encapsulated in futures and options contracts allow price efficiencies to be created ahead of the spot market.
Derivatives absorb risk from risk adverse investors and move it to 'risk hungry' investors to allow the financial ecosystem to function more efficiently.
When Derivatives Exaggerate Volatility
However, in cases of extreme speculation, derivatives can make markets unstable:
Over-leveraged positions lead to cascading losses when markets change suddenly.
Program trading and algorithms cause price changes to amplify, and then to swing wildly, in seconds.
Margin calls in the futures markets result in panic and forced liquidations.
Both the 2020 COVID market crash and the 2008 global financial crises showed how excessive leverage and speculation in derivatives can make volatility systemic risk.
Therefore, while derivatives provide market players with liquidity and efficiency, excessive speculation will provide an underlying market with temporary instability.
Regulation and Transparency: Keeping Volatility in Check
SEBI ensures derivatives trading in India is safe and transparent.
These include,
Safeguarding against the build-up of risk defaults through mark-to-market (mtm) settlement systems.
Real time monitoring of FII and DII derivative exposures.
Netting and settlement systems to manage and reduce systemic risk.
Position limits to control market manipulation.
These systems in-place allow the derivatives market to act as a shock absorber and not a source of contagion.
Conclusion
Derivatives are as much mirrors of the stock market as they are movers.
They reflect trader expectations, measure market fear, and drive price action through leveraging and sentiment.
When used for risk hedging and shifting, they enhance market stability. They can also be used for speculation, generating excessive volatility, and driving the market in the opposite direction.
Derivatives data, including open interest, PCR, and implied volatility, provides powerful insights into market sentiment and potential turning points.
A more balanced view focuses on the fact that derivatives are simply instruments of trading, neutral by design, and hold no potential for good or evil. Any extreme perspective, either of fear or optimism, will ultimately lead to poor decision making.
Fear of volatility, uncertainty, and the potential losses that may come from the use of derivatives will ultimately lead to poor decision making.
