Contract Cycle for
Options in India: a comprehensive guide
Options trading has
become a significant part of financial markets, especially for investors
looking to hedge their risks, speculate on asset prices, or earn premiums
through various strategies. In India, options are traded primarily on stock
exchanges such as the National Stock Exchange (NSE) and Bombay Stock Exchange
(BSE). One crucial aspect of trading options is understanding the contract
cycle. The contract cycle defines the tenure, expiration dates, and other terms
regarding when options are initiated and how long they remain tradable.
This guide aims to
explore in detail the contract cycle for options in India while keeping in mind
factors such as option types, the expiration process, and how these cycles
affect trading strategies.
What is an Option
Contract?
An option contract
is a financial derivative that gives the buyer the right but not the obligation
to buy or sell an underlying asset (like stocks or indices) at a predetermined
price, known as the strike price, on or before a specific expiration date. The
seller (also known as the writer) of the option is obligated to fulfill the
contract if the buyer chooses to exercise it.
There are two types
of options:
Call Option: It gives the buyer the right to buy the asset.
Put Option: It gives the buyer the right to sell the
asset.
The Contract Cycle for Options in India
The contract cycle
for options determines the time duration an option is available for trading,
including the dates of issue and expiration. In India, options follow two types
of contract cycles:
Monthly Contract Cycle
Weekly Contract Cycle (for certain indices)
1. Monthly contract cycle
Most options in
India, especially stock options, follow a monthly contract cycle. This means
that options contracts are available for a maximum of three months, including:
Current month: The month in which the option is issued and
available for trading.
Near month: The subsequent month following the current
month.
Far month: The third month from the current date.
For example, if you are trading in March:
The current month contract is March.
The near month contract is April.
The far month contract is May.
After the
expiration of the current month’s contract, a new far month contract is
introduced. This rolling cycle ensures that there are always three months of
option contracts available for trading at any given time.
Expiration of monthly
contracts
In India, option
contracts expire on the last Thursday of every month. If the last Thursday
happens to be a trading holiday, the contracts expire on the preceding trading
day.
2. Weekly contract cycle
In addition to the
monthly contract cycle, some indices like the NIFTY 50 and Bank Nifty also
offer weekly options contracts. Weekly options are introduced to allow traders
to have more frequent opportunities for hedging or speculation. The weekly
contract cycle follows the same structure as the monthly contracts but with a
shorter timeframe.
Expiration of weekly
contracts
Weekly contracts
expire every Thursday of the week. If Thursday is a trading holiday, the
contracts expire on the previous trading day. Weekly options typically have a
much shorter duration, and because of their frequency, they have become popular
among short-term traders and arbitrageurs.
Example of a Monthly and Weekly Contract Cycle
Let’s take a real-time example to understand how the monthly
and weekly contract cycles work.
Monthly contract example:
If today is March 10,
2024:
The current month contract is March, which will expire on
the last Thursday of March (March 28, 2024).
The near month contract is April, expiring on April 25,
2024.
The far month contract is May, expiring on May 30, 2024.
Once the March contract expires, a new far month (June 2024)
will be introduced, maintaining the three-month rolling cycle.
Weekly contract example
(NIFTY 50 Index):
If today is Monday,
March 10, 2024:
The current weekly contract will expire on Thursday, March
14, 2024.
A new weekly contract starting from March 15, 2024, will be
available and expire on the next Thursday (March 21, 2024).
This way, weekly contracts are introduced and expire every
Thursday.
How the contract
cycle affects trading strategies
Understanding the
contract cycle is crucial for traders and investors because the contract
cycle’s expiry period influences volatility, time decay (Theta), and the
premium of options. Here are several ways in which the contract cycle impacts
different trading strategies:
1. Theta decay and expiry
Options lose value
as they approach their expiration date due to time decay (Theta). The closer an
option is to expiration, the faster the time decay, which means options become
cheaper. For this reason, traders may choose to sell options closer to expiry
to benefit from rapid time decay. Monthly cycles offer more gradual decay over
a longer period, while weekly cycles can exhibit more rapid time decay within just
a few days.
2. Hedging strategies
Traders and
institutions often use options as a hedge against other positions. Monthly
options are commonly used for long-term hedging, while weekly options are
preferred for short-term hedges due to their short duration and frequent
expiries.
For example, a
trader holding a portfolio of NIFTY 50 stocks may buy put options expiring at
the end of the month as insurance against a market downturn.
3. Volatility and expiry
Options tend to
exhibit higher volatility as they approach their expiration, especially on the
day of expiration (Expiry Day). Weekly options can see sudden volatility spikes
as traders square off their positions to avoid assignment or manage risk.
Monthly options experience volatility spikes during the final few days of the
expiration week.
4. Roll over strategies
Many traders roll
over their positions from one contract to another, especially if they hold
long-term views on an asset. For instance, an investor holding a long position
in an option that is nearing expiry can roll over the position into the next
month by selling the current contract and buying the next month’s contract. The
rolling process is a continuous strategy applied at the end of every contract
cycle.
5. Arbitrage opportunities
Since weekly
options expire more frequently than monthly options, short-term arbitrage
strategies are often executed in weekly contracts. Arbitrageurs take advantage
of price discrepancies between different contracts in the same underlying asset
to make risk-free profits.
Market participants
and expiry day dynamics
The contract expiry
day, especially for monthly contracts, is crucial in the Indian options market.
Market participants such as retail traders, institutional investors, and market
makers play different roles in managing risk or capitalizing on market
movements on expiry day.
Institutional investors:
Large funds and institutions often
square off or roll over their positions on expiry day, affecting the overall
market trend. Their activities can lead to volatility in the underlying asset
prices.
Retail investors:
Many retail investors close out their
positions before the expiry to avoid delivery obligations, especially in case
of in-the-money options.
Market makers: They provide liquidity during expiry and play
a critical role in ensuring a smooth transition of positions from one cycle to
another.
Conclusion
Understanding the
contract cycle for options in India is essential for making informed trading and
investment decisions. The contract cycle, whether monthly or weekly, directly
affects strategies related to time decay, volatility, hedging, and arbitrage.
As an options trader, recognizing how the cycle operates can allow you to time
your entries and exits more effectively, whether you are speculating on price
movements or protecting your portfolio from adverse market conditions.
In summary, the
monthly contract cycle is well-suited for medium- to long-term strategies,
while the weekly contract cycle is more favorable for short-term trading and
hedging. Mastering the nuances of these cycles can give you an edge in
optimizing your options trading strategy.
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