One of the proposals SEBI recently made relating to the F&O segment is the rationalisation of index option strikes. This week, we discuss why offering fewer strikes may bode well for traders.
Liquidity factor
Assume that the total number of option contracts traded is fixed. The more the number of strikes offered, the greater the likelihood that the volumes will be spread over a greater number of strikes. Therefore, the liquid in each strike will be lower than if fewer strikes were offered for trading.
Of course, all strikes do not attract the same level of trading interest. Typically, at-the-money (ATM) strike, which is the one immediately above the current spot price, attracts maximum volumes and build-up in open interest. Then, the immediate out-of-the-money (OTM) strike and two after them attract good trader interest. Thereafter, volumes typically decline.
Selecting an optimal strike is a trade-off between time decay and potential gains. If the underlying moves in the direction of your trade, your potential gains are greater for an ATM strike, but so is your loss from time decay. As you move further from the current spot price, an OTM strike offers lower potential gains, and you still suffer losses from time decay.
Balancing time decay and potential gains, it is preferable to choose from the ATM and immediate two OTM strikes. So, why then are farther OTM strikes traded? The reason is price leverage. Consider the August 14 expiry of Nifty options. The 26750 call recorded volumes just over three lakh. The Nifty spot index on that day closed at 24139. Why do traders buy such deep OTM strikes? The obvious answer is the low absolute price; the price of 26750 was 0.55. So, the total contract value does not cost much. If the Nifty Index were to move sharply by expiry, such deep OTM strikes may become in-the-money (ITM). The chance of that happening is less. But the gains (in percentage terms) could be significant if such strikes end ITM.
If the NSE were to offer fewer strikes, traders will focus their attention only on those strikes. That could improve volumes on most available options. Importantly, the change in open interest, which is an indication of liquidity, could increase. This could benefit the position traders. The greater the liquidity, the more the chances that you will be able to close your position later and take profits.
Lesser anxiety
Traders can carry the position for a greater price movement in the underlying without the fear that liquidity will reduce as the lower strike call becomes ITM
Optional reading
With fewer strikes, the concept of tradable strikes may still exist, but it is possible that more ITM strikes will be traded than are currently. This could allow you to trade bull call spread for larger price target; you can carry the position for a greater price movement in the underlying without the fear that liquidity will reduce as the lower strike call becomes ITM. The secondary benefit is that greater the liquidity, less mispriced the ITM and OTM options will be relative to the more liquid strikes.
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