Two chief developments have brought about a renewed interest in the derivatives markets. One- the introduction of 14 new stocks in the derivatives markets. Two- an increasing trend in options trading, especially of Nifty junior. Though the introduction of 14 new stocks has invited flak from the broker and the analyst community alike, there is an underlying point in the two developments: an accurate understanding of investment parameters in order to milk the investment options at hand.

Explains Manoj Mudliar, a derivatives analyst of a leading brokerage, ?The derivatives market is growing and is catering to complex needs of users, in sufficient quantities. Hence, investors need to get their understanding of the investment parameters right to read the trend projected by the markets.? Of all the investment parameters, open interest (OI) is an important barometer used to confirm trends and trend reversals for futures and options contracts.

It is the total number of outstanding contracts that are held by market participants at the end of the day. It can also be defined as the total number of futures contracts or options contracts that have not yet been exercised (squared off), expired, or fulfilled by delivery. It applies primarily to the futures market.

OI measures the flow of money into the futures market. For each seller of a futures contract there must be a buyer of that contract. Thus, a seller and a buyer combine to create only one contract.

Therefore, to determine the total open interest for any given market you need only to know the totals from one side or the other, buyers or sellers, not the sum of both. To give an example, suppose you buy one contract of Reliance 230 calls from an investor A, the open interest is one contract, as is the volume in that option. Subsequently, if you immediately sell the 230 calls to another person, the volumes will increase to two contracts.

The open interest, however, remains at one. The reason: As you have sold an option that you bought earlier, you are out of the market, while another person has entered for the first time. So, this new trader is long one contract, while you are still short one contract. Therefore, the open interest is only one contract.

Benefits of monitoring

By monitoring the changes in the open interest figures at the end of each trading day, some conclusions about the day?s activity can be drawn. An increasing open interest means that new money is flowing into the marketplace. The result will be that the present trend (up, down or sideways) will continue.

Declining open interest means that the market is liquidating and implies that the prevailing price trend is coming to an end. Knowledge of open interest can prove useful towards the end of major market moves. A levelling off of open interest following a sustained price advance is often an early warning of the end to an uptrending or bull market.

An 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 prices while open interest remains flat or is declining may indicate a possible trend reversal.

And herein comes the understanding of implied volatility (IV), which is the market?s perception of the volatility of the underlying security. Says Ajay Shah, an independent scholar and a former member, Sebi?s LC Gupta Committee on Policy for Derivatives (1996), ?The implied volatility is an excellent predictor of future volatility. It tells the stock speculator that he needs to be more or less careful about holding positions on the stock. The most useful implied volatility, of course, is about Nifty. It predicts the overall market volatility, which is a rather useful thing to know.? When dealing in options, you have to consider two kinds of volatilities – historical volatility and implied volatility. Historical volatility is a measure of how much the price of the underlying asset changes, and IV is the market?s perception of the volatility of the underlying security.

Crests and troughs impact

There are two ways to judge how volatility is likely to move in the future. First, is by comparing current IV with the current historical volatility of the underlying security. The implied volatility of a stock should reflect the actual historical volatility of the asset. But this is not the case many a times. The other way is to judge the future IV is to compare the current IV with the asset?s past levels of IV.

If current IV is higher than it has been in the past, it will always return to more normal levels, unless there has been some fundamental change in the company, market, or the economy that will make this asset more volatile in the future. An important feature of volatility is that it tends to revert to the mean.

Says Nitin Jain, derivatives analyst, ?The implied volatility levels of the options help in determining what strategies to be used. When IV is very high, market price of options that has been greater than theoretical price, options are considered ?expensive? and many traders favour premium-selling strategies. Periods of high volatility are followed by periods of normal to low volatility and vice-versa.?

Also, when the volatility level is very high and a fall in implied volatility is expected then this is a premium selling opportunity and when the volatility level is very low and a rise in implied volatility is expected then this is a premium buying opportunity so you can take long straddle (an options strategy with which an investor holds a position in both a call and put with the same strike price and expiration date).

However, there is substantial risk of loss in trading, if one goes by IV, if you get the direction wrong. IV can increase or decrease even without price changes of the underlying security because implied volatility is the level of expected volatility. IV also falls, as the option gets closer to expiration, as changes in volatility become less significant with fewer trading days.

And herein investors can track the Put-Call ratio, a tool specifically designed to help investors gauge the overall sentiments of the market. The ratio is calculated by dividing the number of traded put options by the number of traded call options.

As this ratio increases, it can be interpreted to mean that investors are putting their money into put options rather than call options. An increase in traded put options signals that investors are either starting to speculate that the market will move lower, or is starting to hedge their portfolios in case of a sell-off.

Relevance

An increasing ratio is a clear indication that investors are starting to move toward instruments that gain when prices decline rather than when they rise. Since the number of call options is found in the denominator of the ratio, a reduction in the number of traded calls will result in an increase in the value of the ratio. This is significant because the market is indicating that it is starting to dampen its bullish outlook. The put-call ratio is primarily used by traders as a contrarian indicator when the values reach relatively extreme levels. This means that many traders will consider a large ratio a sign of a buying opportunity because they believe that the market holds an unjustly bearish outlook and that it will soon adjust, when those with short positions start looking for places to cover.

However, there are experts who find no relevance of the ratio. Says technical analyst Ashwani Gujral, ?Doing put call ratios on a daily basis is not too useful. Extreme put call ratios indicate market fear and euphoria as investors and traders buy a huge number of puts in fear and a large number of calls when they are euphoric.? He adds, ?Put call ratios upwards to 1.75, can be assumed to be leaning on the fear side. Any put call closer to 1, generally indicates complacency or euphoria.?

In addition to these investment parameters, the cost involved in derivative contracts is also an important factor to be aware of. It comes into the cost of carry model factor. Cost-of-carry model is an arbitrage-free pricing model. Its central theme is that futures contract is so priced as to preclude arbitrage profit.

In other words, investors will be indifferent to spot and futures market to execute their buying and selling of underlying asset because the prices they obtain are effectively the same.

How it works for you

According to the cost-of-carry model, the futures price is given by:

Futures price (FP)= Spot price + Carry cost – Carry return.

Carry cost (CC) is the interest cost of holding the underlying asset (purchased in spot market) until the maturity of futures contract. Carry return (CR) is the income (eg, dividend) derived from underlying asset during holding period. Thus, the futures price (F) should be equal to spot price (S) plus carry cost minus carry return.

If the futures price (FP) is not equal to spot price (S) plus carry cost minus carry return, there will be arbitrage opportunities as follows: When FP > (S + CC – CR), sell the (overpriced) futures contract, buy the underlying asset in spot market and carry it until the maturity of futures contract. This is called ?cash-and-carry? arbitrage. When F < (S + CC - CR), buy the (under-priced) futures contract, short-sell the underlying asset in spot market and invest the proceeds of short-sale until the maturity of futures contract. This is called ?reverse cash-and-carry? arbitrage.

It makes no difference whether you buy or sell the underlying asset in spot or futures market. The difference in spot and futures price is just equal to the interest cost and the cash distributions.

Perhaps, an outcome like this, stresses the importance of a careful plunge into a derivative contract. What is more important, is gauging the big money and even the bigger risks involved, if you blunder. Though the markets have added up 207 stocks in its kitty, what investors often forget is its intricacies and trade in like the cash market participants to incur huge losses.