Option prices shoot up in anticipation of new government

With election results to be announced on May 16, volatility in the market has increased sharply

Option writers (sellers) are salivating as rising volatility increases option prices. With election results to be announced on May 16, 2014, volatility in the market has increased sharply, thereby increasing option prices. India Vix index, which tracks market volatility, has crossed the 35 per cent mark compared to around 14 per cent when NSE launched the trading of futures in the index. India Vix has a mean of 26.65 per cent and a median of 23.83 per cent.

A sharp rise in volatility has resulted in the price increase of both call and put options. At the money (ATM) options for May expiry are well over one-year high levels. With Nifty touching a new high, the 6800 call option trades at Rs 328 while the put option trades at Rs 238. An option writer earns Rs 566 by creating a short straddle strategy (selling both these options). The last time the Vix crossed 30 on August 28, 2013, the cumulative at the money options were priced at Rs 350.

Volatility plays an important role in option pricing. Over the last one year the average total of call and put option was in the range of Rs 250 at the start of a new settlement. Even when volatility was high during the start of December 2013 settlement (for state election results which were expected to signal the trend in general election) the cumulative value of both the options was around Rs 360.

An option writer hopes to profit from a fall in option prices which takes into account falling volatility and time as expiration nears. The current price of option is nearly equivalent to the theoretical price of the option and hence there is no question of overpricing which these traders are looking at exploiting.

As per a Bloomberg report, the negative correlation (rising India Vix would mean a falling Nifty) between India Vix and Nifty which was observed for nearly six year has broken. Historically, Vix had a negative correlation of 0.8, but is now moving in tandem with the index. This happens at times of a game-changing event. Election results are one such event. The Vix index, also known as the fear index, reflects the anxiety of market participants over the expected results. Analysts are expecting volatility to increase as the results date nears.

Option prices would, however, correct sharply after announcement of results since the “unexpected event” will be over and traders would then take their position based on the new facts.