Implied volatility of options falls sharply on exit polls

MUMBAI: Traders' perception of risk or implied volatility (IV) of options declined sharply on Tuesday after exit poll results suggested the BJP-led NDA will form the next government. But derivatives analysts say options traders or punters could still place bullish bets on volatility rising ahead of the actual counting of votes on May 16 for low to moderate profitability.

"The way the markets have rallied and IVs have risen, I don't see much scope for traders to make hefty returns like what they've made up till Monday's session. But, as IVs have declined from the mid-40 levels to 32 and 35 levels overnight from Monday, traders could still go long vols as these could rise to 42-odd levels ahead of the actual results on Friday," said Yogesh Radke, head of quantitative analysis, Edelweiss Financial Services.

Derivatives analysts believe that unless the NDA wins more than 300 seats, markets are unlikely to spurt as they did recently. Radke believes if, as some exit polls predict, NDA gets 272 seats, the market could test 7200. But, 7500 will be a cakewalk if the NDA gets more than 300 seats.

The fall in IVs was accompanied by a decline in options value. For example, the 7200 call price declined almost 7% to 192.25, while the 7500 call price fell 21% to 71.45. But, despite this decline, Ashish Chaturmohta, derivatives research head, feels traders could play on vols for gains. In the run-up to the 2009 elections, he says, options' IVs rose to almost 60% and so "there's some steam left for traders".

IVs are one of the important determinants of an option's premium - the price at which it trades on the exchange. If IVs rise, so do options premiums or prices. But the sharp movement of the IVs and markets in the last two trading sessions has made traders conservative.

This is also reflected in India VIX, the investor's fear gauge meter or the market volatility index, crashing 13.63% to 32.04 on Tuesday, its biggest fall in more than two-and-a-half years. The reduction in VIX points to a decline in risk premium, which is reflected in the options prices. The only reason why premiums did not fall in line with the decline in IVs is the positive market movement, which cushioned the fall. So, as Radke puts it, unless the seat count increases dramatically from 270-odd to 300 and above, the risk-reward isn't that favourable for investors.

This is borne out by foreign portfolio investors or FIIs' outstanding positions. On Tuesday, FIIs sold almost 20,000 more Nifty put contracts, underscoring their bullish expectations of the market. A put seller received premiums, but if markets decline below the index value minus the premium received, they could be exposed to huge losses.

However, if the NDA does not get a comfortable majority, the fall will be as precipitous as the sharp rise and could singe people who have taken directional bullish bets or purchased call options. But most market experts are confident that the next government will be led by Narendra Modi.

"We don't expect markets to move up much on May 16, unless there is some element of surprise in the poll outcome," said Jitendra Panda, managing director and chief executive officer of Peerless Securities.