Underlying, derivatives market integration to boost investor interest

Indeed, if the two markets - underlying and the derivatives market - integrate well together, we should see increased investor interest (especially around weekly or day options contracts).

More importantly, the interplay between the pair through market-maker hedging mechanism means we could start witnessing “feedback” loops in play. How? Let’s give an example. If customers are buying a particular equity option, the market maker (or dealer) on the other side of the trade must be short. Given that dealers don’t like to take market risk, all of this flow has to be hedged.

To square this risk on their books, they buy either single stock futures or the underlying share. Not doing so will leave them exposed to potentially severe losses as the stock climbs.

Now, buying the underlying may end up fuelling more upside as the market enters into a “positive feedback loop.” Meaning: higher prices beget higher prices as buyers, seeing rising stock prices, buy more call options, which leads dealers to increase their hedges by buying more of the underlying.

The opposite is true for selling put options - a downward squeeze on shares from gamma-induced selling. When a stock is falling, market makers will be highly motivated to sell the stock to hedge their exposure. In all instances, both markets stand to influence each other, dampening and/or increasing volatility in equal measure.

The above scenario was witnessed in the widely reported case of AMD Entertainment - a NYSE listed company, just a few years ago. Huge buy call option volume left market makers with massive short call positions that grew as the share price inched closer to the high strike prices held by the bullish investors.

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As a result, market makers were forced to buy AMC shares to offset their exposure, adding more fuel to the rally - at one point clocking over 100 percent return in just under a week.

In industry speak, this options-related buying pressure is what is known as “gamma squeeze”. As long as dealers are going to serve as the primary counterparty in the local arena, it should never surprise anyone if dealer inventory hedges lead up to a similar “squeeze”.

Throw in “retail friendly” short-term contracts (which is what I think NSE will favour) to the mix, the likelihood for such events increases. Short term contracts are going to be attractive for traders looking to bet on intraday moves but are perfect enablers for exacerbated market moves.

In all, the options market should help re-invigorate the broader market, but attendant risks should be assessed and actively managed. Note: Calls convey a right to buy shares at a fixed price in the future and benefit when shares rise, while puts convey the right to sell and benefit in falling markets.

The writer is the Managing Director, Canaan Capital Limited.