SEBI came up with a circular approving extended trading in the derivatives segment and it will certainly have lot of impact in different ways. We are moving towards being a matured market. However, if you are an options trader and wondering how it will impact your trading pattern; here are a few technicalities which may change as a result of extended derivatives trading.
Option writers are majorly trying to make money from either theta decay in options or volatility drops. Mostly the perceived volatility of the market is higher than historical volatility and that is the opportunity for option writers
Volatility is a factor of uncertainty and more news / events happens outside the trading window more will be the risk as there might not be an opportunity to act immediately.
Gap-ups and Gap-downs are common for an events reactions and this risk keeps the volatility high. With extended trading hours in derivatives the uncertainty becomes lower for a large gap opening due to external events or other global market events. Hence, there will be very little to earn for volatility traders as the volatility will quote slightly lower in general.
Linearity in Theta Decay
The other less known secret in options trading is that Theta decay has a negative convexity during the trading session which means: options prices correct sharply towards the closing hours of the market than it does during the day due to theta decay. Let’s relate to this concept with an example – If you deposit cash in your bank account the bank pays you interest for Saturday’s & Sunday’s even though they might not be working.
Similarly, in options theta decay for rest of the day or for a weekend ahead is discount to certain extent in advance in the last hours of trade creating a negative convexity in option prices. This change is not visible as the implied volatility drops to solve for the Black & Scholes equation.
Now with extended trading hours, the sharp theta decline will no more be a case and the decay will be linear making it difficult for option writers (particularly intraday writers) to make money as the best friend till date ‘Theta’ will not be much of help.
Futures as the underlying reference
As the cash market will close early, the best representative of fluctuations in options will be the futures price. This will lead to changes in calculations of Implied volatility where the spot price will no more be available and it has to be related to its futures price. This is in-fact beneficial as future prices already discounts for interest rates & dividends if any and is the best representative of movement in options.
Increased demand for System based trading
Trading for 15 hours at a stretch may not sound practical to large number of investors and this should increase the demand of systematic trading where based on rules the machines can take care of trade initiation, execution and risk management.moneycontrol