Stocks trade on the market’s expectations of the future value the underlying business will create. These expectations are based on various inputs such as the company’s financial performance trend, news on the company’s products & market and similar news about the other players in the industry. Over the last two decades, the number of possible ways for investors to access information have rapidly grown with the rise of social media, real-time online news sites, and an endless number of market analysts sharing their views.
What has also grown rapidly is instances of sudden sharp moves in stock prices, even in large cap stocks & indices, at a level not seen before in Indian markets. On April 4, 2022, HDFC bank stock jumped 10% and declined more than 20% in the next nine consecutive trading sessions. The Nifty IT index has seen sharp up/down movements over the last one year. During the period from September to December 2021, the index fell 9% or more thrice in eight to 12 trading sessions, and recovered the losses within a week’s time. In 2022, the index lost 18% through February and gained 15%+ in the next one month. The number of such moves suggests that trading in individual stocks has become more risky for the average investor.
The standard industry term used to measure fluctuations in security prices over a given time period is called volatility. The formula for volatility is:
where Pm = average stock price over a given time period, Pc = daily price of the stock on each of the days, n = number of days.
What is causing higher volatility in stock markets? First, increased participation of retail investors trading actively on every piece of company news or macroeconomic data. Since FY20, the share of retail investors in market trading volumes has risen from 38% to 45%, as the number of demat accounts increased 2.2x in FY22. Automated trading systems that trade on sentiment & news flow have also contributed to a larger share of the market. Another factor is the rising volumes of option trading – premiums turnover in the Indian index and stock options in FY22 was 2.1x the turnover in FY21.
Option trading impacts prices of the underlying stocks through an industry practice known as ‘delta hedging’. For example, when you buy call options on a particular stock, you are long the stock, while the seller of options is short the stock. To limit his risk in case the stock price goes up, the seller of options may also buy the stock. Thus, when you buy call options it can have a small upward impact on the underlying stock.
When a large number of market participants buy call options in the same stock, it can have a large impact on the stock. When the options expire, this hedge will also be unwound, causing the opposite move in the stock. Thus, option expiry dates (sometimes referred to as ‘opex’) can have volatile price moves. In India, the last Thursday of the month is the expiry date of Futures & Options contracts.
