Market Scramble: Options, futures trading weigh on Tokyo stocks – Nikkei Asian Review

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TOKYO — The Japanese benchmark stock index stopped just short of 20,000 on Wednesday due in no small part to profit-focused trading in the options market.

“Futures sales are cropping up, and a lot of them are associated with covered calls,” said a trader at a major Japanese brokerage, commenting on the Nikkei Stock Average’s underwhelming 57-point gain to 19,900.

A covered call is a strategy in which an investor sells call options on a stock position to generate income. Many market players predict the Nikkei average will not break through 20,000 in the short term, so contracts with strike prices at or below 20,000 have swelled.

Here is where the futures market comes in: brokerages that purchase calls sold by investors hedge those bets by shorting futures at the start of trading. When the stock market approaches 20,000, the gains in call values will exceed the losses on the short positions. Closing out would lock in a profit, but with the low liquidity of options, the position is effectively unwound by additional shorting of futures.

When prices go down, the value of calls purchased will approach zero, but brokerages will still profit off their short positions on futures. The subsequent squaring of those positions serve to curb market swings.

The same goes for put options: when brokerages receive those sell orders, market swings are dampened. The volume of options transactions has been heavier than usual this year. Covered call trading is expected to rise globally, according to Morgan Stanley MUFG Securities.

Options selling also stands behind the downward trend in the VIX forward volatility index for U.S. stocks. Not only do options sales have an inverse effect on the index, futures trading by purchasing brokerages also puts a lid on stock price movements. A stable market gives rise to more options selling, continuing the cycle.

On Tuesday, the VIX dipped to a low last seen in 1993 when the economy was benefiting from the peace dividend made possible by the end of the Cold War. U.S. defense spending is on the rise now, and the world faces heightened geopolitical risks. Market insiders were left wondering why volatility has declined considering the vastly different circumstances.

The culprit is funds flowing into the options market in search of easy profits. “In this era of low interest rates, investment behavior is geared toward generating income,” said Michiro Naito at JPMorgan Securities Japan. Ironically, even some fixed-income investors are taking on the risky strategy of options selling. The recent lows touched by the VIX “fear index” are masking that exposure.

Options trading has led to biased forward positions amid low volatility, leading to a top-heavy stock market. But an unexpected development could trigger a rush of repurchasing and wider price swings.

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