What do we understand by F&O expiry?
In India, all futures and options contracts are cash settled. Of course, effective from August 2018, stock futures contracts are settled by delivery in case they go into expiry. But a large chunk of F&O contracts are cash settled. This means only the profits and losses are adjusted to the profit and loss account of the trader. F&O expiry falls on the last Thursday of every month and that gets pre-poned by a day if the last Thursday is a holiday. Look at the table below to get an idea about the expiry of contracts.
In the above table, there are three available contracts for Nifty. This includes the near-month contract expiring on October 25, the mid-month contract expiring on November 29, and the far-month contract expiring on December 27. If you are holding on to a Nifty October contract, you have three options in front of you.
What are the reasons for market correction on expiry day?
Some key reasons why markets could correct on F&O expiry day are listed below:
- One of the reasons the markets tend to correct on F&O expiry is because traders try to offload positions ahead of an uncertain month. When traders have a long-term positive view on Nifty, they tend to hold on to futures and rollover to the next month contract. However, when markets are in a state of uncertainty, most traders would not prefer to rollover to the next month. When traders rush in to reverse a long position, there is a sharp correction in the markets. We see a sharp correction on expiry day when uncertainty about the next month looms large.
- Another reason is the existence of reverse arbitrage opportunities. Let us understand this in greater detail. An arbitrage position is when you buy in the cash segment and sell equivalent futures in the F&O segment. The spread is effectively locked in. Normally, the spread turns to zero on expiry day. Sometimes, due to volatility in the markets, the spreads turn negative. This results in a windfall for the trader, and they prefer to unwind the entire position and book the profit rather than just roll the futures position. This results in large-scale selling in the cash segment, causing the markets to correct sharply on expiry day.
- Yet another reason for a sharp correction on expiry day is what is popularly known as VWAP selling. When institutions unwind their arbitrage positions (explained above), they normally let the futures expire and then sell the shares in the last half hour of trading because the closing value of the stocks is the average of the last hour. Hence, they try to sell as close to the value weighted average price (VWAP) as possible. When a large number of institutions do VWAP selling during the last half hour of expiry day, it puts tremendous pressure on the markets, normally leading to a sharp correction in the markets.
- When large institutions plan to sell out on cash positions on expiry day, they tend to play the market via equity and futures. They sell the futures and then time the cash selling in the last hour of trade. When the markets began falling, traders who had tried to play the bounce by going long started to panic and cover their positions. This is a vicious cycle that normally leads to a very sharp correction in the markets. We have seen this kind of correction during the December 2011 expiry, when Nifty fell vertically on expiry day.