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5 things to know about derivatives expiry
You may have noticed that at the end of every month, the stock market becomes more volatile. News reports often say this is because of 'derivative expiry'. It sounds vague and unclear as to how the derivatives market affects stock prices and indices.
Here is a look:
Futures and Options contracts:
Derivatives that are traded on the exchange are of two types - Futures and Options. Both are contracts, which are traded in the exchange. The contract buyer agrees to buy or sell the underlying assets (stocks, in this case) at a fixed price at a future date. Now, if this is a futures contract, then the buyer has to fulfil the agreement at all costs. If this is an Options contract, however, the buyer can let the contract expire without fulfilling the terms of the agreement.
What is derivatives expiry:
The future date by which the contracts have to be fulfilled is called the derivatives expiry. To avoid confusion, the exchange has decided that the contracts can only expire on the last Thursday of every month. If this happens to be a trading holiday, then the previous trading day would be counted as the expiry date.
On the expiry day, the contracts are settled (or simply get expired in case of Options). This can be done by two ways - you can buy another contract which nullifies your contract, or you can settle in cash. For example, suppose you buy a futures contract which allows you to buy 100 shares of ABC company, then to close the contract, you can buy another futures contract which allows you to sell 100 shares. You will then have to pay the difference in the price of the contract. Each contract is traded at a specific value. This is connected to the underlying stock's price in the secondary stock market (cash market)-where you buy and sell stocks directly. So, the settlement value of each contract is tied to the closing price of the stock on the last day.
Why it affects stock prices:
Futures and Options contracts derive their value from their underlying stocks or indices. However, over short periods of term, the derivatives contracts can affect stock prices too. For example, suppose investors are optimistic about the near future. So, the volume 'Buy' contracts increase in the derivatives market in comparison with the 'Sell' contracts. Now, looking at this, investors in the cash market could start buying shares in anticipation of higher prices. When this buying increases in large quantity, the stock price actually rises.
Arbitrage trading on expiry:
A few days or a week before the expiry, traders take stock of their derivatives positions-whether they are truly profitable or not. Often, these traders have stock positions in both the secondary stock market as well as the derivatives market. Sometimes, they may buy from the stock market and sell through the derivatives market to make profits. This is called arbitrage trading. Around the expiry period, such traders may decide to cancel or unwind their positions to avoid losses. In such a case, they may directly sell the stocks in the secondary market itself. There may be other traders who do the exact opposite. Either way, this sudden increase in trading causes price fluctuations. This leads to an increase in volatility in the secondary market. However, this is just for a short period of time. Markets often recoup their losses after the expiry.
Rs 5,78,506 crore
On an average, derivatives contracts worth Rs 2.71 lakh crore are traded daily on the National Stock Exchange (NSE) as of March 2015. This is a 71% rise from the daily average turnover of Rs 1.58 lakh crore in the previous year. Some days, there are more contracts traded. In March 2015, this turnover touched a peak of Rs 5.78 lakh crore. In comparison, the total value of trades in the secondary market is very small. Only a maximum of Rs 26,326 crore-worth trades were conducted on a single day as of March 2015.