11:55pm – It is time to move into uncharted territory

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By Anand James

From October onwards, exchanges would be allowed to extend trading hours of equity derivatives to 11 55pm. Let us see, how this will affect its various stake holders.

Regulator, exchanges and intermediaries

Having brought commodities also under its fold, the present move by the regulator is with a view to integrate various instruments traded under its eye view. Presently, the trading of several instruments start and end at various times; cash and equity derivatives market is open from 9:15am to 3:30pm, commodity futures trade from 10 am to 11:55pm, Stock lending and borrowing (SLB) from 9:55am to 5pm, and currency futures from 9 am to 5pm. So, the desire to seek common start and end points is not difficult to understand, and is consistent with the regulator’s efforts to protect the interest of investors. Moreover, the extended trading timings for derivatives is also the normal in global exchanges. For the exchanges as well as the broking intermediaries, more trades obviously come with hopes of more business.

Investors

SGX Nifty to be less significant as a proxy. Primarily, stock investors stand to gain from having the ability to respond to global events that unfold in the evening, also to stock specific announcements, government decisions etc. Presently, US markets’ close, and SGX Nifty, traded on the Singapore Exchange, along with Chinese and Japanese indices are pivotal in forging the opening sentiments of the domestic market every day. From October onwards, SGX Nifty would hold less of a coveted place in that regard, and the closing price of the derivatives that got to respond to the global events in the evening itself, will also act as a proxy to opening sentiments.

At a micro level, traders of options, futures and cash would be affected differently, by this move. The major reason for the same is not the additional time that the derivatives will now have, but the time that they will trade without any guidance from the cash market, which will close at 3:30pm even as derivatives trade on till 11:55pm. The guidance of cash market is necessitated by the settlement logic of the derivatives, which uses the closing price of the underlying stock/index for settlement price, or F=S*ert, in the case of illiquid contracts, where F and S are the futures and spot prices, respectively. This throws open certain opportunities for futures and option traders.

For the futures, the potential for arbitrage is the most obvious one, while the spot price adjusts itself every morning to the information that its derivative has already priced in from the day before. In reality, the window for such opportunities could be small, but it is an opportunity nevertheless.

For the options, things may not be as simplistic. The essential difference is the make up of both these instruments. Futures are more linear in their price moves as they track spot price closely. In other words, if spot falls, futures also fall almost as much. Options on the other hand, are not dependent on the spot alone. BSM model for option pricing gives weightage to the implied volatility, strike price, time until expiration of the contract, and the interest rate. Of these, two important factors are theta and volatility and the success of an option trader depends on how well he plays them. Let us understand these two theoretical concepts by relating to how they impact real time trading. If you have ever noticed that, some call options refuse to gain as much as other strike prices, despite a stock-positive announcement, then that is partly due to high IV, or implied volatility. Trading cue: High IV is sign for “sell” or “stay away”. Theta, the other important concept is a measure of time decay, or the rate at which option price declines with time. A good understanding of this concept makes an option trader a compulsive seller, because all option prices have to eventually lose value with time. Theta, however does not play up during the day, but becomes evident towards close of day. Now with options set to trade on after cash market closes at 3:30pm, the compression in option prices, that usually happens as theta decay sets in, may not happen, but instead be pushed to later in the day. Not atleast to the same extent. If you look at the formula given below, since there is more τ, time to maturity, time decay will be lower, and the option price will lose less of the time value, at 3.30pm, when compared to present. Theta is defined as:

The reason why, there will still be some decay in the last hour of trade is cash prices will still see compression as leveraged intraday positions get squared off before 3:30pm.

Other expected trading dynamics

  1. Index: The trading interest in index futures and options, especially on Nifty, is likely to be good. So far we have seen that Indian markets fall less in the event of a global market selloff, but now with Nifty open during the US market timings, it may be tempted to react more to the global events. But, do not expect Nifty to match every US moves.
  2. The trading interest in other single stock futures may be more discrete and sporadic.
  3. ADRs: Those stocks with ADRs could see relatively more trading interest, but only time will tell if it would be continuous.
  4. Time specific trades: US markets’ opening, key economic data releases, weekly crude inventory data release etc., will ensure focused money flow at specific times.

Final word

Extended trading is not a new thing. It is in play in US, Japan etc. and has not exactly revolutionized equity trading just by virtue of the extra time. The key question initially would be if expected business from the extra hours will make up for the extra cost by way of personnel and infrastructure that exchanges and intermediaries will have to put in. The burden may not be huge as a significant portion of trades is already done online. For the social structure, it is one more industry that is going to do the long hours. For the Indian capital market, it would be worthwhile to follow the NSE – SGX stand off and the products that could be launched from GIFT. In all, Indian stock market is bracing for new trading dynamics that may not yet revolutionize the industry, but could change the way we look at it.

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