0 A REPORT ON

IMPACT OF OPEN INTEREST ON EQUITY MARKET TRENDS

FOR BMA WEALTH CREATORS

SUBMITTED BY:

TRIPTASREE GHOSH 10BSPHH010843

IBS HYDERABAD

A REPORT ON IMPACT OF OPEN INTEREST ON EQUITY MARKET TRENDS BY TRIPTASREE GHOSH (10BSPHH010843) A report submitted in partial fulfillment of The requirements of MBA Program of IBS HYDERABAD

SUBMITTED TO:
1. PROF KAUSHIK BHATTACHARYA- FACULTY GUIDE 2. MR. INDRA NARAYAN BISWAS- COMPANY GUIDE

BMA WEALTH CREATORS

DATE OF SUBMISSION: 15/04/2011

Table of Contents
ABSTRACT......3 INTRODUCTION.4 MAIN TEXT..9 PLAN FOR COMPLETION OF THE PROJECT................................................................................... 13 REFERENCES.14 ATTACHMENTS.15

ABSTRACT:
This project has been initiated for the purpose of acquainting me with the basics of the financial terminologies used in the stock markets along with the in-depth knowledge on how derivatives work and the impact of open interest on options. There are many factors that affect the option pricing and this project is based on the study of open interest position and how it affects the investment decisions. Open Interest (OI) is the total number of outstanding futures/options contracts that are not closed or delivered on a particular day. The project is mainly divided int0 two phases and the first phase has been completed till date. The first phase involved collection of two years NIFTY options data from the NSE website. Then the data have been sorted out as most active calls and puts based on OI positions. After that a strategy was formulated where in net profit or loss obtained through this strategy is calculated. As per the strategy, one lot of most active call and one lot of most active put options (based on OI) is shorted in the market. Along with these, I have also studied the relationship between price and OI and how exactly do the turnover, OI position and price indicate whether the stock price will go up or go down (i.e. whether the stock will be bullish or bearish). This study was done on futures of the following companies/ indexes: TATA CONSULTANCY SERVICES (TCS) RELIANCE (RIL) STATE BANK OF INDIA (SBIN) NIFTY BANK NIFTY

INTRODUCTION:
Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. The emergence of the Derivatives market is an ingenious feat of financial engineering that provides an effective and less costly solution to the problem of risk that is embedded in the price unpredictability of the underlying asset. In India the emergence and growth of Derivatives market is a recent phenomenon. Since its inception in June 2000, the derivatives market has exhibited exponential growth both in terms of volume and number of traded contracts. According to the latest volume of rankings for the first half of 2010 by the Futures Industry Association (FIA), National Stock Exchange (NSE) of Indias ranking has improved by two places and its now the fifth largest derivatives exchange in the world. Section 2(ac) of Securities Contract Regulation Act (SCRA) 1956 defines Derivative as: a) a security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security; b) a contract which derives its value from the prices, or index of prices, of underlying securities.

There are different kinds of Derivatives. Our study is mainly focused on FUTURES and OPTIONS.

FUTURES:

Futures is a standardized forward contract which enables an investor to buy (long) or sell (short) the underlying asset at a specified price at a specified future date through a specified exchange. Futures contracts are traded on exchanges that work as a buyer or seller for the counterparty. Exchange sets the standardized terms in terms of Quality, quantity, Price quotation, Date and Delivery place (in case of commodity) etc.

Following are the important types of financial futures contract:i )Stock Future or equity futures, ii)Stock Index futures, iii)Currency futures, and iv)Interest Rate bearing securities like Bonds, T- Bill Futures. To give an example of a futures contract, suppose on November 2010 sangita holds 1000 shares of ABC Ltd. Current (spot) price of ABC Ltd shares is Rs 115 at National Stock Exchange (NSE). Sangita entertains the fear that the share price of ABC Ltd may fall in next two months resulting in a substantial loss to her. Sangita decides to enter into futures market to protect her position at Rs 115 per share for delivery in January 2011. Each contract in futures market is of 100 Shares. This is an example of equity future in which Sangita takes short position on ABC Ltd. Shares by selling 1000 shares at Rs 115 and locks into future price.

OPTIONS: In a broad sense, an option is a claim without liability. It is a claim, contingent upon occurrence of certain conditions. Thus, an option is a contingent claim. More specifically, an option is a contract that gives the holder a right, without any obligation, to buy or sell an asset, at an agreed price, on or before a specified period of time. The option to buy an asset is known as a call option, and the option to sell an asset is called a put option. The price at which the option can be exercised is called an exercise price or a strike price.

OPTION BUYER/HOLDER

OPTION SELLER/WRITER
Obligation to sale the underlying asset at strike price if the option holder desires

CALL OPTION

Right to buy underlying asset at strike price

PUT OPTION

Right to sale the underlying asset at strike price

Obligation to buy the underlying asset at strike price if the option holder desires

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The asset on which the call or put option is created is referred to as the underlying asset. Depending on when an option can be exercised, it is classified in one of the following two categories: European option: when an option is allowed to be exercised only on the maturity date, it is called a European option. American option: when an option can be exercised any time before its maturity, it is called an American option. Example: On 9th of this month, X buys Nifty near month 5300 call option @73.5 from Y (current market price 5260). The expiry date is 27th. So here the strike price is 5300. Premium is 73.5. X is the option buyer/holder and Y is the option writer/seller. Option type: European. During the expiry we can have the following possibilities. As per theoretical concept, if Nifty is above 5300 on expiry say 5425: a) X has the right to buy Nifty at 5300 from Y and Y is obliged to sell it if X desires. b) Net gain of X will be (5425-5300)-73.5=51.5 and net loss of Y will be (53005425)+73.5= -51.5 c) X has a chance to have unlimited gain (above 5373.5) but maximum loss will be limited to 73.5 only (if Nifty closes below 5300) d) Y has a chance to have unlimited loss (any point above 5373.5) but maximum gain will be limited to 73.5 only.

There are various factors like strike price, time remaining until expiration, volatility, risk free Interest Rate, Open Interest position that affect the investment decisions. This project is mainly focused on the study of open interest (OI) positions and how it can be used as an effective tool while formulating strategies so that investors can gain from the options irrespective of volatility in the market.

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OPEN INTEREST DEFINED: Open Interest is the total number of options and/or Stock Future contracts that are not closed or delivered on a particular day.
Time Trading Activity Open Interest On Jan 1, A buys an option, which leaves an open interest and also creates a trading volume of 1. On Jan 2, C and D create a trading volume of 5 and there are also 5 more options left open. On Jan 3, A takes an offsetting position and therefore, open interest is reduced by 1 and the trading volume is also 1. On Jan 4, E simply replaces C and therefore, open interest does not change and the trading volume increases by 5.

Jan 1 Jan 2

A buys 1 option and B sells 1 option contract C buys 5 options and D sells 5 options contracts
Trading Activity

1 6

Time

Open Interest

Jan 3 Jan 4

A sells 1 option and D buys 1 option contract E buys 5 options from C who sells 5 options contracts

5 5

What Does Open Interest Tell Us

A contract has both, a buyer and a seller. As a result, these two market players combine to make one contract. The open interest position that is reported each day represents the increase or decrease in the number of contracts for that day, and it is shown as a positive or negative number. A consequent increase in open interest, along with an increase in price, is said to confirm an upward trend. Similarly, an increase in open interest, along with a decrease in price, confirms a downward trend. An increase or decrease in price while the open interest remains flat or declines may indicate a possible trend reversal. The main objectives of the project are: To study the impact of open interest positions on NIFTY options(most active call and put option in the near month expiry) Based on the study frame multiple profitable NIFTY option strategies so that investors can gain from the options irrespective of volatility in the market.

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LITERATURE REVIEW:

1. Mihir Dash, Kavitha V, Deepa K M, Sindhu S, November 2008, A Study of Optimal Stock & Options Strategies: It is widely believed that the performance of pure-stock portfolios can be enhanced by incorporating different options strategies, the most popular strategies being covered-call writing and protective-put buying. The study considers a class of stock and options strategies, involving a long or short position in a stock, combined with a long or short position in an option. The study applies these strategies to a sample of one hundred and twenty-seven stocks listed in National Stock Exchange F&O segment, using corresponding stock options and tries to find out which of these strategies yields maximum returns. It also tries to relate the optimal strategies and the returns from the optimal strategies to the characteristics of the distribution of returns of the underlying stock. The findings of the study indicate the strategies that were optimal in two ways: one type of strategy that was optimal at the lowest strike price and whose payoff decreased with increase in strike price, and the other type of strategy that was optimal at the highest strike price and whose payoff increased with increase in strike price. It was found that only the standard deviation, skewness, and kurtosis of the returns distribution of the underlying stock affected the optimal strategy. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1293203

2. Chen, Zhiwu, Bakshi, Gurdip S. and Cao, Charles, Review of Financial Studies, October 1999, Do Call Prices and the Underlying Stock Always Move in the Same Direction? This article empirically analyzes some properties shared by all one-dimensional diffusion option models. Using S&P 500 options, we find that when sampled intraday (or inter-day), (i) call (put) prices often go down (up) even as the underlying price goes up, and (ii) call and put prices often increase, or decrease, together. The results are valid after controlling for time-decay and market microstructure effects. Therefore, one-dimensional diffusion option models cannot be completely consistent with observed option-price dynamics; options are not redundant securities, nor ideal hedging instruments---puts and the underlying asset prices may go down together.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=183108

9 MAIN TEXT:
The project is divided into two phases. 1. FIRST PHASE: a) The first phase is mainly based on collection of two years options data from the NSE website. Then the data is sorted-out based on OI positions. After that a strategy is formulated where in net profit or loss obtained through this strategy will be calculated. As per the strategy, one lot of most active call and one lot of most active put options (based on OI) is shorted in the market. b) Study of the relationship between price and OI and how exactly do the turnover, OI position and price indicate whether the stock price will go up or go down.(i.e. whether the stock will be bullish or bearish on short term basis). This study was done on futures of the following companies/ indexes:
TATA CONSULTANCY SERVICES RELIANCE STATE BANK OF INDIA BANK NIFTY NIFTY

2. SECOND PHASE: During the second phase based on the findings from the first phase I will try to design multiple NIFTY option strategies so that investors can gain from the options irrespective of volatility in the market.

The first phase of the project has been completed and will form the major part of this report. The part a of the first phase begins with the collection of Data ( Nifty call and put options for the previous two years i.e. April 2009 to February 2011 and also the recession period data i.e. September -November 2008) from NSE website. Yearly data as well as other high frequency data (monthly, quarterly or daily) is available there, and hence the modeling of the data has been extended to these high frequency data to better capture the volatility in precision and hence increase the efficiency. After the data has been obtained the following steps have been undertaken:

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1) An excel sheet has been maintained where in the data collected is systematically divided into monthly data and from which most active call and put options(based on OI position) have been calculated. example:

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2) The next step involved formulation of a strategy and calculation of net profit or loss obtained through the strategy. The strategy involves hypothetical shorting (selling) of one lot of most active call and put into the market each day. For e.g. suppose on 1st of May 2010(expiry 28th May) the most active call option is NIFTY 5300 @ 50. So according to the strategy adopted one lot (i.e. 50 call options) is shorted in the market. The net inflow is Rs.2500 (50x50). 5300 NIFTY call option continues to be most active for the next few days and so there is no activity in the market. Again on 9th of May 5500 NIFTY call option becomes most active. The moment 5500 becomes most active, one lot of such active option is shorted in the market and the previously shorted option (in this case 5300) is squared off. In this way on the expiry date we obtain either a profit or a loss.

DATE

ACTIVITY 27-Jan-11 sell 5800 CE 28-Jan-11 no activity 31-Jan-11 no activity 1-Feb-11 sell 5400 CE & 5800 CE sq off 2-Feb-11 no activity 3-Feb-11 no activity 4-Feb-11 no activity 7-Feb-11 no activity 8-Feb-11 no activity 9-Feb-11 sell 5100 CE & 5400 sq off 10-Feb-11 no activity 11-Feb-11 no activity 14-Feb-11 sell 5400 CE & 5100 CE sq off 15-Feb-11 no activity 16-Feb-11 no activity 17-Feb-11 no activity 18-Feb-11 no activity 21-Feb-11 no activity 22-Feb-11 no activity 23-Feb-11 no activity 24-Feb-11 option expired

LTP 55.5

NET INFLOW 2775

OUTFLOW

NET PROFIT/LOSS

106

5300

557.5

34.65

1732.5

8100

45.15

2257.5

350

3057.5 PROFIT

3) After the calculation of net profit/loss the change in the nifty (the difference between the closing price of NIFTY in the beginning of the month and the closing price at the end of the month) is obtained and compared against the result obtained. 4) On the basis of the comparison done various observations are made which will help in formulating multiple NIFTY options strategies.

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From the strategy adopted the inferences drawn are: Market flat to range bound (up or down by 200 points) the strategy is a gainer. When there is high volatility within the range bound in the market this strategy is a gainer After a long consolidation period when there is a break out writing call and when there in a break down writing put options should be avoided When there is a dip in market the loss from the put options is being compensated by the profit from the call options. Another observation is that writing put option is more profitable when there is less volatility in the market directions. The more the volatility the less is the amount of profit earned on put. After a long period of consolidation when the market breaks out the loss from the call options is so high that it is not being compensated by writing put options Whenever there is any economic downturn like recession this strategy doesnt hold good. A Call option's premium consists of both intrinsic value (if any) plus time value. As time passes, the time value portion of the Call erodes (i.e., decays). At expiration, the Call's value will equal its intrinsic value. *All the excel sheets are included in the attachments.

The part b involves tracing the daily movements in the futures of INDEX/STOCKS. The stocks selected are the Reliance, SBIN and TCS and the indexes selected are BANKNIFTY AND NIFTY respectively. Every day, when the market closes the last traded price, open interest position, and turnover of the above mentioned stocks/index are recorded systematically in an excel sheet and on the basis of change in price, turnover and OI, observations are made as to whether the stock prices will go up, stay neutral or go down in the days to come (2-3 days). With the help of the above study it is also tested whether the following theoretical rules of open interest actually work in the real life scenario. RULES OF OPEN INTEREST: If prices are rising and the open interest is increasing at a rate faster than its average, it is a bullish sign. This indicates that more participants are entering the market, involving additional buying, and any purchase is generally aggressive in nature If the open-interest numbers flatten, following a rising trend in both, price and open interest, it should be taken as a warning sign of an impending top High open interest at market tops is a bearish signal if the price drop is sudden

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An unusually high or record open interest in a bull market is a danger signal. When a rising trend of open interest begins to reverse, a bearish trend can be expected.

The findings from this study are that most of the times whenever there is rise in price with a rise in open interest it indicates bullishness (i.e. the stock prices will go up). Decrease in price but increase in open interest indicates bearishness. If prices are in a downtrend and open interest is on the rise, it can be said that new money is entering the market, displaying aggressive new short selling. This scenario will prove out a continuation of a downtrend and a bearish condition. Lastly, if the total open interest is falling off and prices are declining, the price decline is being caused by disgruntled long position holders being forced to liquidate their positions. Thus the findings can be summarized as: Bullish An increasing open interest in a rising market Bearish A declining open interest in a rising market Bearish An increasing open interest in a falling market Bullish A declining open interest in a falling market

PLAN FOR COMPLETION OF PROJECT:

16th April to 9th May: Based on the results obtained from the first phase frame multiple profitable NIFTY option strategies so that investors can gain from the options irrespective of volatility in the market.

10th May to 12th May: Final editing of the project and compilation of final report

14 REFERENCES:
TEXT BOOKS: I.M PANDEY: Financial Management M Y KHAN- Indian Financial Systems R MAHAJAN- Futures and Options Rene M.Stulz- Risk Management & Derivatives Options As A Strategic Investment- Lawrence G.Mc.Millan

NEWSPAPERS: Economic Times Mint Business Line

WEBSITES: CAPITALINE (software provided by the Research Dept) www.bmawc.com www.indianderivatives.com www.bloomberg.com www.icharts.in www.jstor.org/ www.google.com/finance
www.scholar.google.com/

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ATTACHMENTS:
MOST ACTIVE CALL AND PUT OPTIONS (APRIL 2009-FEBRUARY 2011):
Microsoft Office Excel 97-2003 Worksheet

Most active call and observation (April 2009- January 2010)

Microsoft Office Excel 97-2003 Worksheet

Most active call and observation (February2010- February 2011)

Microsoft Office Excel 97-2003 Worksheet

Most active put and observation (April 2009- January 2010)

Microsoft Office Excel 97-2003 Worksheet

Most active put and observation (February2010- February 2011)

NET PROFIT/LOSS ON STRATEGY ADOPTED

Microsoft Office Excel 97-2003 Worksheet

Net profit/loss on shorting of most active call/put and analysis

MOST ACTIVE CALL AND PUT RECESSION(SEPTEMBER-NOVEMBER 2008)

Microsoft Office Excel 97-2003 Worksheet

Most active call & observation

Microsoft Office Excel 97-2003 Worksheet

Most active put & observation

NET PROFIT/LOSS ON STRATEGY ADOPTED

Microsoft Office Excel 97-2003 Worksheet

Net profit/loss on strategy adopted and analysis

DAILY ANALYSIS OF INDEXES/STOCKS

Microsoft Office Excel 97-2003 Worksheet