Understanding the Basics for Trading VIX in India

National Stock Exchange of India Limited (NSE) is all set to launch trading on Volatility Index Futures (VIX) from 26th Feb, 2014.

Let us discuss about VIX Futures, Its trading, Advantages and  Lacunae(If any).

The Circulars pertaining to launch, Contract Specification and Settlement are (here),(here).

What is VIX ?

VIX  was launched on CBOE and it is their trademark (here). In India Volatility index(VIX) is a measure of Implied volatility on Nifty Options or we can say it the expectation of volatility for next 30 day. VIX is always calculated for next 30 day only.

VIX is calculated using Implied volatility (IV) of all out of money calls and Puts of Near month and Mid month of Nifty. To know more about computation methodology Refer (here), (here),(here).

Simply, VIX would be one number, which will help us look at the expected market volatility / Nifty volatility  for next 30 day. Eg: If there is budget / Result season next month, we can expect that number to be higher, as the market will be more volatile.

Can we trade on VIX ? Also some more details ?

Yes, We can trade in VIX futures in India. It will be available for trading on derivatives segment of NSE from 26th Feb, 2014. The Lot size of VIX will be minimum Rs 1 Million. VIX will be traded on derivatives segment of NSE. The contracts will have weekly settlement and there will be 3 weekly contracts available for trading. Effectively you can take a view of IV for 30 day after 21 days.

The final settlement of the contracts will be Tuesday's (I guess on other days, there can be impact of bias in IV, like on Friday late session, the IV tend to fall because of Theta value of weekend etc). The final settlement of VIX contract will take place on average VIX price of last 30 minutes of trading on Tuesday.

The Contracts are cash settled and the settlement will take place on T+1 basis, along with other derivatives contract. Also Spread contracts will be available for rollover.

The Margins on VIX futures would be at least 15% , But I believe it will be more (Up to 20% to 22%) because of volatile nature of VIX Futures. Also the benefit of spread margin will be available on VIX futures.

Also STT is also applicable on VIX futures, which will be same applied on Index Futures

What is the Use of VIX ?

a) VIX is used as a single number to predict the expected volatility for next 30 days.

b) It can be the tool for hedging.

c) It can be a volatile product to trade.

d) It also has predictive power on expected volatility

e) Historically It has negative co-relation with nifty futures. So If Nifty goes up, VIX tends to fall and vice versa.

f) Arbitrage is also possible both covered and Statistical.

How do we trade on VIX Futures?

a) Speculation : A Person can take a view on expected volatility and trade based on it ,Beware It will be very volatile, at least 5% a day.

b) Hedge : A Portfolio investor can hedge his portfolio by buying VIX (Inverse relationship)

c) An Investor can take position on VIX based on his Option Portfolio. He can hedge his gamma 

d) VIX futures is helpful in volatile times as you can take view on VIX, as VIX futures does not suffer decay (Theta)

e) An Arbitrageur can also indulge in spread trading on VIX futures.

What are the USP of VIX Futures?

a) There is higher volatility in VIX compared to VIX itself, Hence It is a volatile product which may lure traders.

b) Institution Investor are interested in VIX as a hedge, Thereby creating depth in market.

c) Cash Settled.

d) The computation of VIX is shown on NSE screen, every second.

Is there any Shortcomings / Lacunae in VIX Futures ?

a) It is very volatile product. On a single day, there will be moment of at least 5%, means a person can gain/ lose Rs 50,000/- in a day in 1 lot.

b) The Life of contract is very small only 21 days.

c) The expiration of VIX futures and Index Futures do not fall on same day, hence a difficult arbitrage.

d) Rollover will be very expensive as you will have to pay STT every week.

All in all , VIX is a new product to trade, but It is not meant for soft-hearted people. I feel that VIX futures will be Restructured in future to get broader participation. Also the Life of VIX futures needs to be increased. 

Also note that VIX Index or Implied volatility is always higher than realised volatility in normal times.

 

This is not a recommendation to anybody whatsoever to buy OR sell this share, but it is my thought process and views on this topic.

I welcome your critical comments and suggestions.

 

Rationalisation of Rules in Periodic Call Auctions for Illiquid Scrips

Today SEBI came out with revised guidelines for Periodic Call Auction (PCAS) in equity market (Here).

Also before we understand, what changes are done and how it would impact the stock criteria, I would request you to please refer my previous blog on this topic for smooth continuation (Here).

With this circular, SEBI has rationalised criteria for stock becoming eligible for PCAS. Effectively SEBI has bought down the eligible universe to only small cap and illiquid stocks.

Impact of New Circular :

a) All Stocks which has a daily turnover of more than Rs 1 Million will not come under PCAS. (Effectively SEBI has moved from selection criteria of Quantity and Number of trades to Value of trades. A very rational move)

b)  All Stocks which has a market cap of more than Rs 10 Crore will not come under PCAS.

c) All consecutive dividend paying companies will not come under PCAS (For last 2 years out of 3 years)

d) All companies which are profitable consecutively will not come in PCAS (For last 2 years out of 3 years) along with less pledge of share (Not more than 20%)  and Book value of more than 3 time the face value.

e) Previously If stock goes in PCAS, It has to be in PCAS for 2 quarters, which is now reduced to 1 quarter only

f) All Un-executed orders in PCAS can be carried forwarded to next PCAS auction for same day.

Well, SEBI has effectively kept only small cap, penny stocks in PCAS, Which are illiquid and also non profitable in the ambit of PCAS. So most of the stock will be out of PCAS now. 

So now PCAS will be a dead segment and now It will die a natural death in long run, because now there wont be many companies in PCAS and they would be very illiquid.

As stated in my previous blog, SEBI has to make amendments in rules of PCAS segment, but now they have liberalised most companies out of PCAS

This is not a recommendation to anybody whatsoever to buy OR sell this share, but it is my thought process and views on this topic.

I welcome your critical comments and suggestions.

 

Periodic Call Auctions for Illiquid Scrips

SEBI recently came out with circular (here) asking exchanges to transfer all illiquid stocks in call auctions from 1st April, 2013.

In this circular SEBI has said that

a) Allow Pre-opening Session in all liquid stocks.

b) Transfer all illiquid stocks in Periodic call auction.

From 1st April, 2013 all stocks, if they are liquid, would be available in Pre-opening session, which is a welcome move.

Also all illiquid stocks will be available only in call Auction. Let us first understand the meaning , features, advantages,dis-advantages and deficiency  of Call Auction and also its impact on price discovery.

What is Call Auction ?

Call Auction is trading mechanism where all buy and sell orders are pooled together and trade takes place at a equilibrium price at which maximum buyers and sellers are ready to trade. There is only a single discovered price for every call auction. The Price discovery process for call auction is same in Pre-opening session, except that you have more time for order placing, modification and cancellation.

There are around 260 Stocks which are illiquid as per latest NSE circular.

What are Illiquid Stock :

Illiquid stocks are stock which are infrequently traded and generates lesser trading volume. Generally stocks which have low equity, low Floating stocks , Stable stocks, or the companies which do not have more of speculative interest are mostly illiquid stocks,  but we should not infer that all stock which are illiquid are not fundamentally good companies. That may be true for some companies.

NSE criteria for illiquid stocks are High Bid - Ask Spread, Low Volumes, Higher Impact Cost, infrequent trades etc. SEBI has defined a broad criteria that Stocks which have average daily volumes of less than 10000 shares, and which have daily average of less than 50 trades are considered illiquid on all exchanges where the stock is traded. 

When would a stock become liquid from illiquid :

When the above mentioned parameter are not met by stock, it becomes liquid stock and it will be transferred to normal segment, but once stock becomes illiquid, it will be in call auction category for at least 2 quarters

The Salient Features of call auction as per SEBI circular are :

a) Call Auction for illiquid stocks would take place every hour during trading session. Out of 1 hour, 45 min will be allowed for order placing, next 8 minutes will be for order matching and last 7 minutes will be buffer / cooling off period. To avoid fake orders to distort price, the closing time of call auction will be random between 44th and 45th minute.

b) After the closure of each call auction, pending orders will be purged / cancelled.

c) Price bands will be applicable as per Risk Management rules of exchanges and It may also settled on trade to trade basis.

d) There is penalty on people generating false volumes by simultaneously being a buyer and a seller at the same price.

Are there advantages of Call Auction : Yes

a) Call Auction leads to better price discovery , also thereby reducing outlier trades.

b) A bigger order book can be generated using call auction.

c) It reduced volatility in stocks due to illiquidity.

Are there any Dis - advantages / Lacunae in Call Auction :

a) The Computation for Illiquid Stock of SEBI is flawed, because it looks only at volumes and not on any other parameters like Bid - Ask spread, Impact Cost etc. Most High value stock would tend to become illiquid as they may not pass the test of average 10000 shares

b) There are many prop desk who have different people working at different locations and on different strategies at the same time on different mandates, also their decision making is decentralized. They may also have Chinese wall between traders. In such scenarios it may happen that some trader at one office of a prop desk may be selling that stock and another trader of that same prop desk may be buying at the same time. Though such trades may not be artificial volumes but such trades will attract penalties.

c) The pending orders are cancelled after every call auction, hence a buyer or sell will lose his priority in case of UP or Down circuit. Also it will be cumbersome to give new orders and track trades after every call auction.

d) Intraday trading in this stocks will be marginalised.

e) Margins will be higher in call auction segment comparatively.

f) Disclosed quantity in orders are not allowed in call auction, hence bulk order and block orders will be disclosed in market before the deal taking place, which may put parties looking to buy or sell big quantities in disadvantage.

Once the bulk order or block order is discovered on stock, many traders would try to create nuisance value. The traders would try chasing the bulk or block deal.

Conclusion : Call auction are there in many international market and academics prefer call auction to normal trading in illiquid stocks and I would need to read more of academic papers to speak on international experiences. But I would like to put suggestion and experience about the same

a) Whenever in India if a stock is transferred in T2T segment, the stock most of the times tend to drift downwards, because liquidity players would not give quotes, Call Auction also reduces speculative element from such stock. So maybe we can see the price of stock always trading at discount to its fair value, till the time it is traded in call auction.

b) Can we look for Market Maker in such illiquid stock rather that trading in call auction. Many developed markets including US prefer market makers.

c) There is only one stock as of now which is listed on SME segment of exchanges, there is hardly any volume in the stock. These stock is only traded in call auction, can we get a pre-cursor of the happening. I would want to qualify that the view can be biased as there is only one stock as of now.

We should be happy that SEBI is working for better market place and  I am sure we can expect some amendments in current call auction procedure to make it more market friendly

This is not a recommendation to anybody whatsoever to buy OR sell this share, but it is my thought process and views on this topic.

I welcome your critical comments and suggestions.

Destiny of IFCI : Will it again be a PSU

On 24th Aug, The Cabinet Ministers of India decided to convert Optionally Convertible Debentures of IFCI to the tune of Rs 923 Crores at PAR. Post conversion government will directly hold 55.57 % of IFCI and up to 68.31 % of IFCI if we take into account the stake of other PSU in IFCI. There was full disclosure in the annual reports of IFCI about the conversion at Par subject to SEBI guidelines on Takeover.

We will also look at the background of IFCI,

The Industrial Finance Corporation of India (IFCI) was converted into a company incorporated under the Companies Act, 1956 on 31.3.1993. It was then decided that holding of Government controlled institutions in IFCI should be maintained above 51 percent.

In the wake of likely systemic impact of IFCI defaulting on its liabilities, in the year 2001, the Government infused Rs.400 crore as Tier-l capital of IFCI in the form of 20 year 9.75 percent unsecured Convertible Debentures. This was a cash neutral transaction.

Thereafter, in December 2002, the Government had approved a financial assistance of Rs.5220 crore to IFCI which was to be released over the period from 2003 to 2011-12. Out of the package of Rs.5220 crore, financial assistance of Rs.2932.31 crore (Rs.523 crore as loan in the form of OCDs and Rs.2409.31 crore as grants-in-aid) was released. In 2006-07 the company started making profit and it was decided to stop release of further assistance to IFCI. The OCD terms said that IFCI can repay OCD to government.

The equity holding of Public Sector-Banks / Financial Institutions / Insurance Companies remained over the threshold limit of 51 percent till March 2004. Thereafter dilution in the holding took place in 2005 and it came below 51 percent.

Further,

Committee of Secretaries was constituted, headed by the Finance Secretary and comprising of Secretaries from the Departments of Economic Affairs, Expenditure and Financial Services. The Committee, after due consideration and taking into account all the facts, has inter-alia recommended to convert the OCDs of Rs.400 crore and Rs.523 crore into equity at par and that the Government need not make an open offer to the shareholders of IFCI and instead take exemption from SEBI under Section 11(1) of the SEBI (Substantial Acquisition of shares and takeovers) Regulations, 2011. 

Let the understand the impact of this conversion :

a) IFCI will become a Public Sector Undertaking (PSU), which will come under the ambit of bureaucracy, which may lead to delay in decision making.

b) The Expected EPS of FY12 will fall from around Rs 8 to Rs 3.60.

c) The price of Equity shares before the conversion was around Rs 35/-, After the conversion keeping other things same and Increasing the capital and decreasing the debt by Rs 923 crores, The new value comes to Rs 21 /-. (Cost of Equity)

There is a direct diminution in the value of IFCI call for us to see it lens and raises the question of Bureaucracy against Minority Investors. There are several points to look into the conversion of OCD.

a) Can Government convert the OCD in Equity?  Yes It was in the terms when OCD of Rs 523 Crores were  issued, also the Prevailing Market Price at time of issue of OCD was below Par, We should also understand that IFCI has received grants to the tune of 2409 crores.

About the issue of OCD worth 400 crores , it was a cash neutral transaction to maintain Tier I capital of the company. Also IFCI has the right to Prepay these OCD, I am not too sure How can government convert it in shares, effectively values of that Rs 400 crores become much more because of conversion, whereas IFCI investment of Rs 400 Crores in GSec does not change.

b) Can IFCI challenge such conversion : I doubt about it, The conversion is as per agreements, but which may not be bad in law but it may be bad in  spirits ? It is an executive order by CCS, where Law and State Machinery are part of it.

c) What about Minority shareholders : Minority Shareholders stand to lose, because of conversion. There was a disclosure for conversion, along with that it was mentioned that the conversion will have to follow Takeover guidelines. As per the guidelines, The government will have to buy 26% shares from minority shareholders as per SEBI formula of offer Price. But Instead the government choose to take exemption from SEBI u/s 11(1).

As per section 11(1), The SEBI board can grant exemption from making an offer for acquiring shares under the regulation after recording the reasons in writing from acquirer and if it is in the interest of investors in securities and the securities market.

I fail to understand, how exemption is in interest of Investors or Market, It seems these section is invoked to not make open offer.

d) Can SEBI look in the Matter : NO and Yes. SEBI cannot stay the conversion as they are as per terms and condition of OCD, but YES SEBI can take a stand on Open offer, I don't know how can SEBI get convinced that such exemption is in the interest of the Investors and markets. These will be a case for SEBI , where its stand for Investor Protection may be compromised.

As of now It does not seem that SEBI will be able to stand for Investor Protection and its stand may be compromised.

What about the future: IFCI as an institution is regaining its dominance, but after the conversion  there are areas where clarity will emerge only in future

a) Decision making may become slow.

b) IPO of one of its subsidiaries will be delayed, reducing its valuation

c) The talks of inducting a strategic investor will be a thing of past

d) Its biggest blessing in disguise may be that they may get a banking licence , which is also in distant future.

The returns of IFCI minority shareholders in long run will vindicate government action for conversion of shares.

I welcome you critical comments and suggestions

The MCX Equity Exchange : Can it make a mark ?

Yesterday, MCX got a permission to start an equity exchange, sounds good as it will add to product list which can be traded, but can we make a list of what may or may not happen after this development.

It makes me think that with a long history of being an oldest exchange, if BSE is struggling with volumes, how would new exchange garner volumes. BSE generates volumes in derivatives only because of LEIPS (Liquidity enhancement program), where the traders are compensated for the statutory cost else there is no volumes in derivatives exchange

Then how can MCX make its mark ?

a) MCX intends to replicate success of MCX commodities and to some extent Currencies in Equities, but we must know that i) MCX & NCDEX started trading at around the same time, when neither had lead nor volumes.ii) Today MCX has volumes but if we dissect the volumes, they are mostly speculative and only in Metals, where delivery in very miniscule, whereas NCDEX commands higher volumes in Agri Products and huge quantities are marked for deliveries. iii) There is miniscule institutional participation in MCX whereas Big Trading houses and Many MNC procure through NCDEX. 

In Equities , to garner volumes you need the participation of Retail Investors, Traders, Prop Desk and also Institutions, but if we look at the above instance Institutions don't trade on MCX. It needs to be seen, How can MCX get institutional investors on board.

b) The biggest advantage of MCX, is that it has trading software and the required domain expertise in creating a back-end of trading in place. Thanks to support of its parent Financial Technologies. ODIN software (A front-end software for trading) was the only player until before some time, but now there are many other software vendors, but its still the leader.

c) I am also concerned about the risk management and work ethics in MCX, They need to come out with strong risk Management and strict code of secrecy and work ethics of its employees.

What can MCX do to make a mark ?

I believe that MCX  will have to differentiate their products to attract more players and different breed of players.

a) The first and foremost is they should try with delivery based Stock futures and options : There is a strong demand for delivery based derivatives in Indian market, but NSE is reluctant to introduce this as there is a fear of loss in volumes and NSE trading structure for cash and derivatives segment is different as such that they cannot introduce deliver based derivatives, whereas IF MCX goes on lines of Clearing members and Trading Members for equity brokers also, they will be able to introduce delivery based derivatives.

Incidentally all institutions are for delivery based derivatives and this is an opportunity that MCX can grab, because if Big breed of Institutions trade in MCX, then others are there to follow.

The Basic rational is Institutions have to run VWAP on Expiration day to close their positions and they expect volumes for VWAP, which they get only in NSE as of now, but if the stock futures are delivery based, they need not worry about the delivery, but volumes will follow as stocks will be marked for delivery.

b) In the same manner , they can trade in American options instead of European option and institutions would be a  more comfortable in such trades and it will also create sophisticated arbitrages opportunities for complex trades, which they will love.

c) The biggest obstacle wold be INDEX, It will have to create its own INDEX to trade, but they have opportunity like they can also introduce trading in MSCI index and other such index, which are maintained by big institutions and tracked by foreign investors.

d) SEBI guidelines for Derivatives market  mandates the structure of Trading Member and Clearing Member, such structure in Equities will also help MCX to garner its long list of small brokers and avoid Risk Management issues.

MCX will also have to overcome some regulatory issues like :

a) SEBI may move to supreme court for a stay in ruling, further increasing the waiting period.

b) SAT has mandated to reduce their stake in MCX below 10% in 18 months, which will impact its valuations.

Looking forward, we can look at MCX equities exchange as an opportunity for different class of investors and to satisfy their investment needs.

I welcome your critical comments and suggestions