chapter-3 literature review - shodhganga...sandeep srivastava, surendra s yadav and p k jain (2008)...

A Study of Derivative Trading Strategies in Indian Stock Market

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CHAPTER-3

LITERATURE REVIEW

3.1 Introduction

3.2 Derivative Trading Strategies

3.3 Option Trading Strategies

3.4 Option Spread Strategies

3.5 Theoretical Analysis

3.6 Conclusion

References


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“We want something more than mere theory and preaching now, though.”

Sherlock Holmes

3.1 INTRODUCTION

Researchers, Scholars, Teachers, Academicians, Students and Practitioners get ideas

though reading and life-long process of learning. In the present study also, reference of

related literature has been used. Various studies have been carried out to understand

derivative trading strategies, option trading strategies, option spread strategies and the

application of such studies.

The focus here in this study is not to understand option spread strategies in its

traditional sense. The focus here is to understand what are the popular trading

strategies used by analysts, parameters or factors used for the design and construction

of these spreads and also the effectiveness of these strategies compared to naked

options. For that various research papers, working papers, and articles were referred.

The purpose of referring them was to understand the gap in various studies carried out

in the past as well as derive supportive evidence for some of the findings of such

studies.

Figure 3.1 Snap-Shot of LITERATURE REVIEW

Source:-Developed by Researcher

As you can see from the figure, Literature review is done in three phases.

Derivative Trading Strategies

Option Spread Trading Strategies

Design & Structure


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3.2 DERIVATIVE TRADING STRATEGIES

There has been a substantial change in investment strategies used by active

investors in Indian stock market over the past five years. Investors have shifted

from purely technical analysis to both fundamental and technical- whether its

cash market or derivative market. One of the most challenging areas

in derivative is increased volatility. In few minutes one can earn fantastically or

erode his capital. The complex nature of derivatives with surge in volatility has

created a diverse range of trading strategies to be explored and used by traders

in order to earn returns and minimize risk. Each derivative product in itself is a

different world since they take on completely different characteristics. Trading

in futures are poles apart from trading in options. Options are more complex

than futures. They are a distinct class of derivative instruments.

Sandeep Srivastava, Surendra S Yadav and P k Jain (2008) surveyed broker‟s

assessment of market activity and their perceptions of derivative trading in

Indian markets. He found that derivatives have penetrated into Indian Stock

market and investors are using these securities for different purposes like risk

management, profit enhancement, speculation and arbitrage. High net worth

individual and proprietary traders account for a large proportion of broker‟s

turnover.

Sushismita Bose and Sumon Kumar (2007) analyzed the impact of derivatives

contracts on the cash market and found that trading volumes were significantly

higher on expiration days and during the five days leading up to expiration days

compared with non-expiration days(weeks)

Rohini Singh (2009) discussed the advantages/disadvantages of using

derivatives. Further Evaluated the pay offs from options and their

combinations. As far as investment analysis is concerned, she appreciate the

role of Futures in Portfolio management.


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Corporate hedgers can hedge the speculative bubbles by having insurance in

form of options against potential bubbles at all times , Analysis done by Damir

Tokic ESC Rennes – International School of Business, Rennes, France “When

hedging fails: what every CEO should know about speculation”.

Large insurance companies need to fit the use of equity and bond derivatives

within an overall coherent financial management policy, Straightforward

futures and forwards contracts have proved to be the most versatile and useful

form of derivative. While option-based strategies can be essential for producing

structured retail products. (Dr Joseph Mariathasan ,2000)

Derivative use by banks operating in India is hypothesized to improve their

intermediary function. The research outcome identifies the influence of

derivative use on the growth of advances by banks. Bank participation in

advances increases with increase in hedging activities through futures.

(Madhumathi Rajendran,2007)

A survey conducted by Eurex (Major European exchange for derivatives) and

financial news on the use of derivatives in the European fund industry reveals

that the general trend points to an increase in the use of options in the

professional portfolio management among institutional investors.

There have been few research papers based on retail investor awareness and

how they perceive derivative products, like N.Ramanjaneyalu and Dr. A.P.

Hosmani (2010) highlighted the need for awareness among retail investors.

Asani Sarkar (2006) has done the analysis of various derivatives products

available for retail investors. Rohini Singh (2009) discussed the

advantages/disadvantages of using derivatives. Anjali Chokshi (2010) studied

the investor‟s perception regarding Derivative market in India. Ashutosh

Vashistha and Satish Kumar (2010) proposed that innovation of derivatives

have redefined and revolutionized the landscape.


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3.3 OPTION TRADING STRATEGIES

Options have come a long way. Once considered as „niche products‟ are now

well-established and proven investment tools. Asset management firms can use

options as professional tools to manage their investments. During volatile

markets, investors tend to favor value safeguarding investment products. Index

based option strategies such as protective put strategies are especially suitable

for this purpose.

Alok Dixit, Surendra S Yadav and P K Jain (2010) examined opinion of trading

member organizations/brokerage firms on the state of options pricing in Indian

Securities market and found options market is a less attractive destination and

majority are not aware of Put-call parity relationship. Also majority felt that

existing measures on derivatives education are inadequate

E.V.P.A.S.Pallavi1, Dr. K. S. S. Rama Raju2 and Dr. T. Kama Raju3 (2013)

studied Operational strategies and performance of options trading in India and

found that Options can be used to create portfolio with unique features, capable

of achieving investment objectives. Options are used world over to hedge not

only the portfolio risk but also to maximize the return on investments.

Sandeep Srivastava ( 2003) studied role of open interest and trading volume

from the stock option market in determining underlying asset prices in cash

market .He found that these parameters have significant explanatory power and

one can formulate profitable trading strategies based on it.

Bhuyan and Chaudhury (2001) have examined the role of options market‟s

open interest in conveying information about the future movement of the u.a

and have shown that the trading strategies based on this predictor yields better

results as compared to the buy-and-hold and passive covered call strategies.

P.Varadharajan and Dr. P.Vikkraman (2012) studied the same thing on NSE

Stock options using the Open Interest Price Predictor given by Bhuyan and


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Chaudhary (2001) and found that open interest of the underlying have the same

trend pattern as then closing price of the underlying stock. This study proves

that the activity in the equity options market contain useful information about

future stock price that can be used for trading purposes.

According to the Black and Scholes (1973) option pricing model, the option

price is determined only by five input factors. Bollen and Whaley (2004) find

evidence suggesting that net buying pressure affects options‟ implied volatility,

which suggests that option prices are affected by demand. According to their

research, there are more index puts traded than index calls. However, the

opposite is observed for individual stock options. Their findings suggest that

the index put buying pressure drives the change in volatility of index options,

while the stock call buying pressure drives the change in volatility of stock

options. Intuitively, the demand for calls and puts would be different in rising

and falling markets. When the market becomes more volatile, the increasing

volatility results in higher prices for both calls and puts.

Off Late the Volatility indices have gained lot of attention and momentum.

Today it is another leading market indicator which every trader watches

closely. (Roy Antony and Dr Y.V Reddy,2002)

An investor who is holding a portfolio and who is worried about the value of

portfolio falling down over a period has two options. The first option is that the

investor can sell part of his holdings and buy them back later at a lower price.

But if the investor wants to protect himself during the downturn and participate

during the uptrend, he can use the protective put strategy. An investor who

purchases a put option while holding shares of the underlying stock from a

previous purchase is said to be employing a „protective put‟ strategy. As P.A.K

Preethametc (2008) studied this strategy in the Indian stock market on S& P

CNX NIFTY using different maturities and option series. The analysis was

constructed by assuming a long position in European style options on NIFTY

from the time they were introduced in India on June 4, 2001. The returns using

put options are then compared to the returns on S& P CNX Nifty Index. The


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analysis revealed significant profitability in investing in the one-month expiry

Volume-based Protective Put Strategy.

Other Empirical Studies also have demonstrated that such strategies achieve a

risk-return ratio that is significantly more attractive than that of the underlying

security- Call option writing also. Adam M and Maurer R (1999)

Trennepohl and Dukes (1981) is among the earliest empirical research to test

option writing and buying return. Merton,Scholes and Gladstein (1978)

concluded that certain option strategies like fully covered writing strategy have

been successful in changing the patterns of returns and are not reproducible by

any simple strategy of combining stocks with fixed income securities. Covered

strategy is a combination of the stock with its respective option. The strategy

can give good returns in the long run compared to the traditional approach of

long term investing in stocks.

Michael L. Hemler and Thomas W. Miller, Jr (2015) studied the performance

of Option Based Investment Strategies. Using data from January, 2003, through

August, 2013, they examine the relative performance of options-based

investment strategies versus a buy-and-hold strategy in the underlying stock.

Specifically, using ten stocks widely held in 401(k) plans, they examine

monthly returns from five strategies that include a long stock position as one

component: long stock, covered call, protective put, collar, and covered

combination. To compare performance we use four standard performance

measures: Sharpe ratio, Jensen‟s alpha, Treynor ratio, and Sortino ratio.

Ignoring early exercise for simplicity, they find that the covered combination

and covered call strategies generally outperform the long stock strategy, which

in turn generally outperforms the collar and protective put strategies regardless

of the performance measure considered. The findings suggest that options-

based strategies can be useful in improving the risk-return characteristics of a

long equity portfolio.


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Kapadia and Szado (2007) examined the buy-write strategy on the Russell 2000

Index. Using returns over the period 1996–2006, they conclude that “the buy-

write strategy can outperform the index.”

Absolute stock market returns are predictable by options volume while returns

per se are not, call and put volume offer useful information on the future

behavior of stock and futures markets. ( Teppomartikainen and vesaputtonen

,1996)

David landis (2005) mentions about using options in her article on how to win

in any kind of market. She suggest simple conservative strategies of using

options like buy protective put, sell OTM puts, sell covered calls and long

leaps.

Dr. Ritu kothiwal; Mr. Ankur goel(2012),in review of trading/marketing

strategies of futures and options in India , lists top 9 trading strategies in

derivatives as Buy call, Buy put, Buy futures and sell call, Bull spread, calendar

spread, strangle, straddle, stock insurance, sell call & put.

Charles J. Higgins (2011) studied options in a different way. Options are

bought to hedge (insure) or to speculate on securities. He examined the sale of

options in a conservative approach (in lieu of limit orders) and in an aggressive

approach (in lieu of margin interest expense). He examined aspects that are

lesser known in terms of option level approvals, option use in lieu of limit

orders, and no interest expense versions of speculative leverage.

3.4 OPTION SPREAD TRADING STRATEGIES

The strategies discussed above were plain vanilla strategies i.e using only one

type of option- either call or put along with position in stocks. We can also

create a plethora of strategies using call and put together with different

maturities and option series- Spread Strategies, Pair Trading Strategies etc.

Option spread trading has become increasingly popular with active traders and


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investors. Option spread strategies is a best way to counter the effect of implied

volatility. There are various types of spreads major ones are -vertical bull and

bear, straddle and strangle strips and straps, Butterfly and condor, horizontal

spreads etc. Option spreads and combinations are used to

create trading portfolios with heightened sensitivity to one or more of the

determinants of option prices and reduced sensitivity to others. The straddles,

strangles, bull and bear spreads, and butterflies thus created enable traders to

exploit expected changes in the price of the underlying asset, its volatility, or

the time to expiration while minimizing their exposure to the other risks.

Rick Thachuk (2000) in trading techniques suggest that Option spreads can be

beginner friendly. They offer greater risk/reward trades and allow minimally

capitalized traders to enter volatile markets safely. It helps traders especially

those with small sized account balance to trade expensive markets at little cost

and with little risk.

Paul Brittain and Carley Gamer (2006) studies came out with 8 proven but

simple option strategies in which they suggested the trading methods which are

easily understood and easy to employ. They suggest these strategies to be

proven effective option plays. The strategies were a combination of plain

vanilla- and spread combinations.-Short call, Short put, bull call spread with a

naked leg, bear put spread with a naked leg, call ratio spread, put ratio spread

and synthetic long call and put option. They used Strike price, Volatility, Greek

Letters and Support & Resistance points in Technical Analysis as major

parameters.

An-sing Chen and Mark T. Leungz (2003) studied at the money straddle

options on foreign currency futures using direct forecast method versus the

conventional option trading strategy of basing trading decisions on a two-step

procedure of first generating a volatility forecast and then inputting the

volatility forecast into an appropriate option pricing model to price the straddle.

He found that the direct forecasting strategy is more profitable than the


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conventional two-step method. He relied on implied and historical volatility

along with trading volume and open interest.

In order to eliminate all risk in one direction, Edward laporte (2011) suggested

turning iron condor into iron cockroach using Chicago board option exchange

volatility index. Iron condors are also called short strangles. These strategies

are non-directional. It involves selling an at-the-money straddle or strangles and

waiting for volatility to collapse, hopefully realizing a profit in the meantime.

Option traders wait for the volatility index to reach its peak so that they can sell

option premium at elevated levels even in strikes out of the money. An iron

condor is the simultaneous sale of a vertical call and vertical put spread in the

same expiration month with the same size spreads while an iron cockroach is

the simultaneous sale of a call spread and a put spread in the same expiration,

with one spread being wider than the other. The wider spread can be created

with call or put spread depending on the bullish or bearish bias. The focus more

was on volatility and strike price.

Chirag Babulal Shah ( July 2013 ) studied Bull Call Debit spread strategy on

Nifty Index Option. He back test the Bull Call debit spread strategy for a time

period long enough to cover the various practical scenarios of the capital

market. A period of 6years is taken into consideration and a algorithmic

method of back testing is used. The study does not look at any other factors

such as market sentiments, the global scenarios, macro or micro economics,

etc. The Bull call debit spread strategy is a very basic and easy to understand

and implement options strategy. This strategy has proved to yield profits in

the long run. The reason for the profits is the extent of loss when one goes

wrong compared to the profit when one goes right.

Green and Figlewski (1999) examine the forecast of stock volatility and return

of option writing. They find that at-the-money stock index calls have a high

probability of producing large losses, with larger losses for longer time to

maturity. Writing options with a delta hedge reduces the writer‟s risk exposure

compared to naked writing, but risk is still considerable. The practice of option


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writing has increased steadily in recent years, and some practitioners apply

relatively complicated hedging techniques to manage writing risks (Collins;

2007).

Research done by Bondarenko (2003), Coval and Shumway (2001), examine

the returns of strategies that involve puts and calls. They report that strategies

involving put options offer good returns and that put options are more

expensive than calls of comparable distance from the money.

Maheshwari (2013) concludes that market participants majorly retail

participants may not be experiencing efficient markets, due to lack of

education, liquidity and transaction charges. This is true in the current scenario

as retail traders and investors view options as a highly leveraged instrument apt

for speculating. However speculation does not always work and these investors

shy away from derivatives markets once they burn their hands with leveraged

losses.

Another strategy called option straddles also has received less attention as the

primary aim of the studies. Nevertheless, because of their hedging properties,

straddles have been investigated directly for their execution, performances and

characteristics related to market, firms and investors. To maximize the expected

profitability in stock options trading, Mehta (1982) presented an integer

programming model for obtaining the optimal number of calls and puts.

Peterson (1977) analyses the issue of why large commodity futures traders hold

a large percentage of their portfolios in straddle positions. In the study by

Moschini and Lapan (1992), the authors reveal that, under certain assumptions

of the market and the firm, straddle positions not only raise expected utility by

reducing income risk but also influence the firm‟s input decisions. The use of

short straddle positions may implicitly alter the firm‟s belief about the output

cash price and provide the firm some degree of flexibility. In another corporate-

related study, Nhon (1998) describes the use of unbalanced straddles (i.e.,

straps and strips) and shows how these combination positions can reduce the

inventory procurement costs to below-market prices.


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3.5 THEORETICAL AND MARKET ANALYSIS

Her-jiun sheu and Yu-chen wei (March-April 2011) studied option trading

based on volatility forecasting using price data on Taiwanese stock market. He

found straddle trading the best and used parameters like Volatility, Advance

Decline Ratio, Market Turnover(Trading Volume/No of shares listed in

exchange),Volatility Index, Put Call Trading Volume and Open Interest Ratios

Another extensive study was based on vertical bear and bull spread by J. Scott

Chaput and Louis H Ederington (2003). Data on options on Eurodollar futures

were examined for the design and trading of vertical spreads, also called bull

and bear spreads. A bull call spread is created by buying a call option at one

strike X1 and selling a call with the same expiration date at a higher strike, X2.

As compared with simply buying call option X, the bull spread buyer gives up

the additional profits if the underlying asset price rises beyond X, but also

lowers the cost of the spread and therefore curtails losses if the underlying asset

price does not rise as anticipated. You can also create bull put spread on the

same lines. He found that vertical spreads are an important trading strategy.

60% of vertical spreads are debit spreads which implies to reduce net price and

increase the profit like hood on long positions than to limit potential losses on

short positions. Thirdly both strikes are out of the money in over two thirds of

vertical spread significantly higher on debit spreads. They used a widespread of

parameters for the analysis viz Trade type(Call or Put),Strike price Levels,

Buy/Sell Indicator, Time to maturity in months(Expiration Month),Trade Size

in No of Contracts, Spread Delta, Spread Vega, Spread Gamma & Theta,

Implied Volatility and Strike Price Gap

Simple strategies suggested by Frank D. Cholly and Frank J. Cholly (2009) ,for

profit making without incurring too much risk are Buy ATM puts, Buy far

OTM puts and buy a vertical bear put spread. Options allow you to tailor a

strategy to a specific event allowing to greater profits on limited risks, if you

are right.


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Tom Preston (2008) ,emphasized the relation of vertical spreads with time

decay. He says with passing of time option , option was drop in price. So it all

has to do with option time decay and having it on your side by selling options

Volatility and time decay risks are significantly minimized in ATM Vertical

Spreads. Also one can make big-ticket earnings play on a small budget. (Alex

Mendoza, (2013).

When you are unsure of the direction and the timing of the move of the market,

initiate a long term long volatility strategy. The cost of long term option

strategy can be offset by selling shorter- dated options.(Dan Keegan,2009)

Short Option strangle strategy is a better strangle strategy .It requires a trader to

estimate relevant high and low strike prices between the trade date and

expiration. The upper and lower price ranges are also useful for any put or call

sales or purchases as they show what the market is currently expected related to

future price spread.(Paul D. Cretein,2009)

When you are already huge up and you want more but at the same time don‟t

want to give it back, investor can convert a winning long position into a bull

call spread. It achieves both the goals, limiting the downside and maintain the

opportunity to profit further. (Frederic Ruff,2007)

All manner of spreads involves considering various parameter choices in terms

of whether to use call or puts or both, when to use these strategy, strike price

levels and gaps, profit or loss potential, sensitivity of various factors affecting

option premium and its effect on strategy.


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3.6 CONCLUSION-THE GAP

Option spread trading has become increasingly popular with active traders and

investors. Option spreads involve purchase one option in conjunction with the sale of

another option. If managed properly, these spreads offer greater expected risk/return

characteristics than futures and even outright purchases of call or put options.

Given the importance of this topic to understanding market for these spread strategies,

numerous Empirical studies investigated the option strategies in European and

United Countries.

However, the relatively new and emerging equity markets in the Asian-Pacific region

have not been tested extensively to determine spread strategies used by traders in

Indian stock market & to know their perceptions & preferences relating to various

aspects of the Indian stock market.

The basic characteristics of these spreads are discussed in every derivative text and in

the practitioner literature such as McMillan (1980), but to our knowledge spreads and

their combinations have been largely ignored by researchers. No researcher has

examined their design and trading in depth. No one has asked how these spreads

should be designed theoretically and no one has examined how they are structured in

practice in Indian markets. Using a unique database for one of the most active option

markets, Options on Nifty Indexes, we seek to fill this gap by documenting use of

these trading strategies. We seek to fill this void by examining the design and trading

of all spread strategies in the Indian Option market. Indian Derivative market is still

unexplored for these effective & important derivative trading strategies.

Fundamental factors behind this can be awareness, abnormality of Indian markets,

knowledge & usage of products etc. In fact in international markets like US, investors

use more options than future and cash product. India has to go long a way to increase

the usage of these products and changed the whole picture of Indian derivative market.

Hence there is a gap as far as research on option spread trading strategies with

respect to derivatives is concerned. This study aims to bridge that gap. This study

therefore undertakes the academic research of Option Spread Trading Strategies in

Derivative Market with almost higher degree of worthiness and effectiveness. The


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literature review helped to determine the variables or parameters to be investigated

while creating these strategies. Furthermore as many as 25 variables have been

identified in literature and guidelines on operationalizing these variables were

provided. This provided an initial pool from which the final 12 variables were selected

for data collection.

Fig 3.2-Variables Identified from Literature Review

Source: Developed by Researcher

3.6.1 VARIABLES DEFINED

1. Trading Volume-Volume is the number of shares or contracts traded in a

security or an entire market during a given period of time. For every buyer,

there is a seller, and each transaction contributes to the count of total

volume. That is, when buyers and sellers agree to make a transaction at a

certain price, it is considered one transaction. If only five transactions

occur in a day, the volume for the day is five.

2. Strike price Gap- The various price gaps at which different option contract

are opened for different underlying assets.

Variables

Strike Price Gap

Time to Expiration

Advnace Decline

Ratio

Volaitility index

Trade Size

Call Or Put

Type of Spread

Open Interest Ratios

Put Call Trading Volume

Volatility

Greek Letters

Trading Volume


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3. Time to expiration- A specified time, after which the options contract is no

longer valid. The expiration time gives a more specific deadline to an

options contract on top of the expiration date by giving a time of day. The

expiration time was not be the same as the last time to trade the option.

4. Advance decline ratio- A market-breadth indicator to compare the number

of stocks that closed higher with the number of stocks that closed lower

than their previous day's closing prices. To calculate the advance/decline

ratio, divide the number of advancing shares by the number of declining

shares. The A/D ratio can be calculated for various time periods, such as

one day, one week or one month.

5. Volatility Index- The Volatility Index is the ticker symbol for the Chicago

Board Options Exchange (CBOE) Volatility Index, which shows the

market's expectation of 30-day volatility. It is constructed using the

implied volatilities of a wide range of S&P 500 index options. This

volatility is meant to be forward looking and is calculated from both calls

and puts.

6. Trade size- The number of shares being offered for trade at a specified bid

price, that a trader is wasing to trade at that bid price.

7. Put call Ratio- The put-call ratio is a ratio of put options to call options.

The put-call ratio has long been viewed as an indicator of investor

sentiment in the markets. Times where the number of traded call options

outpaces the number of traded put options would signal a bullish sentiment

and vice versa.

8. Type of spread- Spread refers to the difference between bid and asks prices

of an asset. In an option spread refers to the purchase and sale of an option

of the same class but of a different series. Type of spread refers to the

spread created by call or put option.


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9. Open Interest Ratios- Open interest is the total number of options and/or

futures contracts that are not closed or delivered on a particular day.

10. Put call Trading Volume- It is the trading volume of the put options to the

trading volume of the call options on a given trading day or period.

11. Volatility- Volatility measures the amount and speed at which price moves

up and down, and is often based on changes in recent, historical prices in a

trading instrument. Commonly, the higher the volatility, the riskier the

security.

12. Greek letters- Greek Letters are special characters to measure the

sensitivity of option prices. There are many factors affecting option prices.

Each factor has a Greek letter associated with it. Such as Delta, Gamma,

Theta, etc.


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