The futures and options segment has seen several changes in recent times. The latest change is the shifting of the contract expiry date on the NSE from Thursday to Monday with effect from April 4. This week, we discuss (more as food for thought) the possible impact of this change.
Volatility changes
The impact of the change in the contract expiry date is likely to be more on options than futures. This is because futures contract typically moves one-to-one with the underlying. Also, futures price converges with the underlying price at expiry. So, whether a futures contract expires on Thursday or Monday, it is likely to move with the underlying during the life of the contract and will be the same price as the underlying at expiry. Importantly, futures do not suffer from time decay as options do.
Volatility is an important factor is determining an option price. The weekly options on the Nifty Index trade for five days but are priced for seven days, including the weekends. Previously in this column, we discussed whether pricing options should be based on calendar days or trading days. Suffice to know that this does not matter because you are likely to choose an option based on its relative cheapness. That is, it is preferable to buy an option based on its implied volatility, not on its absolute price. So, whether you calculate the implied volatility for five days or seven days for all the options, their relative cheapness will remain the same. But why is this argument relevant to the change in contract expiry date?
Option price consists of intrinsic value and time value. The time value of an option consists of implied volatility and time decay. Assuming implied volatility remains the same through the life of the contract, an option’s time decay will come from its remaining time to expiry. Whether you use calendar days or trading days to price an option, the time decay process will remain the same even after the expiry date changes from Thursday to Monday.
But implied volatility is unlikely to remain the same. It is possible that volatility on Friday is higher when contracts expire on Monday because of the weekend effect. Rather than take high risk because of political and other events that may unfold during the weekend when the markets are closed, many traders may decide to close their positions on Friday, leading to high volumes and higher volatility on Friday than on the other trading days.
Time decay
Whether you use calendar days or trading days to price an option, time decay will remain the same even after the expiry date changes from Thursday to Monday
Optional Reading
There are many ways option traders may react to the change in contract expiry date. Currently, many traders close their positions on Friday to avoid increase in margins during the contract expiry week. This could shift to mid-week after the contract expiry date changes. It is best to wait and observe how the trading pattern unfolds after the contract expiry date changes before you make a meaningful shift in your trading style.
(The author offers training programmes for individuals to manage their personal investments)
