CHAPTER-4 RESEARCH METHODOLOGY 4.1 Introduction to Problem Statement 4.2 Approaches to the Problem 4.3 Research Questions 4.4 Research Design 4.5 Sample Design 4.6 Period of Study 4.7 Data Analysis 4.8 Scope of Study 4.9 Significance of Study 4.10 Limitations of Study Chapterisation Chapter 1-Introduction Chapter 2- Derivative Trading Strategies Chapter 3-Literature Review References 64
4.1 PROBLEM STATEMENT How can investors in India improve their Derivative Trading Strategies? In last two decades derivatives have become very popular risk management tools. Derivative products futures and option itself are big products. Each product has its own construction and working. In a world without options, the basic investment choice is to simply buy or sell a share of stock. One of the unique aspects of options is the ability to combine positions and design the payoff structure, which best suits your expectations. This gives rise to a plethora of trading strategies-plain vanilla, spread strategies, pair trading strategies and sky is the limit. Option spread trading has become increasingly popular with active traders and investors.author Russell Rhoads in his book Option Spread Trading: A Comprehensive Guide to Strategies and Tactics discusses spread strategies that can be used to profit from a strong up or down directional move in a stock, a stagnant market, or a highly volatile market. He also details how you can harness the leverage of options to create a low-risk position that provides the potential for a big profit. When dealing with option spreads you re looking to purchase one option in conjunction with the sale of another option. If managed properly, these spreads can provide experienced investors with the potential for large returns without undertaking a great deal of risk. Indian derivative markets are still unexplored for these proven and effective derivative trading strategies. 4.2 APPROACHES TO THE PROBLEM The review of literature and theory revealed that the option spread strategies had received considerable support. It helped to determine the variables or parameters to be investigated while creating these strategies. Furthermore as many as 12 variables have been identified from literature review which was included in the data collection. 65
4.3 RESEARCH QUESTIONS 1. Which are the most popular Option spread trading strategies in Indian Derivative market for any given market outlooks? 2. Which are the most used parameter choices of these strategies? There are various types of option spread strategies used for different market outlooks. The researcher wants to know the most popular ones used by respondents in terms of their usage and effectiveness in different market outlook. Also the widely used variables by them for these strategies would be highlighted. 4.3.1 Objectives of the Study To examine the performance of the five popular types of option spread strategies in four different market outlooks (Bullish, Bearish, Stable and Volatile) Vertical Bull Spread Vertical Bear Spread Strangles Straddles Butterfly Spreads To compare and contrast the design and structure of these strategies in practice. To understand the effectiveness (Success) of these strategies in the Indian markets vis naked options All major market outlooks used in market are taken into consideration. 4.4 RESEARCH DESIGN The Study tries to find out from the Derivative analysts their design and structure of the spread strategies. 66
This can be explored by carrying out a study of Derivative Research Analysts in India Exploratory followed by descriptive study since it empirically studies the important factors considered by analysts in using these strategies. 4.4.1 Method of Data Collection: 4.4.1.1 Primary Data: Data collected from the Derivative Research Analyst using semi structured interview process with the support of semi structured questionnaire. 4.4.1.2 Secondary Data: Data collected from various sources of print (newspapers, magazines, journals, research reports and books) and electronic media (websites, e-journals and databases).the details are given as references at the end of the thesis. For the Theoretical study of the performance of the option spread strategies, following data is used:- The closing index values of Nifty for the last Thursday are selected for the period 1 September, 2012-September, 2013. The strike price, open, high, low, close and settle price,number of contracts traded and turnover for nifty call and put options being traded on NSE s F&O exchange for the last Thursdays for the period September, 2012 September 30, 2015. Only European Nifty Index as the underlying asset is selected for the strategies since it has highest volume compared to stock options in 12-13.(82,08,77,149 no of contracts and 2,27,81,574.14 Rs crores turnover in Index options in NSE compared to 6,67,78,193 no of contracts and 20,00,427.29 Rs crores turnover of stock options ) Data are required for only last Thursday of every month since options traded on NSE expire on the last Thursday of every month and all the strategies studied here are executed on the day of expiry. 4.4.1.3 Data Extraction: 67
The closing Index values of Nifty for the last Thursdays of all the required months were obtained from the www.nseindia.com. The strike price, open, high, low, close and settle price, number of contracts traded and turnover for nifty call and put options being traded on NSE s F & O exchange for the same period was also obtained from the same site. The structured questionnaire was developed keeping in mind the 12 variables identified from the literature review. The questionnaire was then sent to 10 experts from the industry as well as academics for pilot testing. Their suggestions and feedback are incorporated in the questionnaire and final questionnaire was drafted. The final questionnaire is attached in Annexure 1 & 2. Also to find the analysts, a pilot survey was carried out to find the analysts trading in option market. The analyst was divided into two categories-corporate Analyst and Individual Analyst. 4.4.1.4 Data Processing: To study the performance of options spread strategies theoretically, the 12 variables derived from literature review have been considered for creating strategies. These strategies are then compared with how these spreads are constructed on option markets. 4.4.1.5 Research Instrument Primary data was collected using structured questionnaire as a tool. For the study, questionnaire was designed taking into consideration the 12 variables derived from the literature review. 1. Trading Volume-Volume is the number of shares or contracts traded in a security or an entire market during a given period of time. For every buyer, there is a seller, and each transaction contributes to the count of total volume. That is, when buyers and sellers agree to make a transaction at a certain price, it is considered one transaction. If only five transactions occur in a day, the volume for the day is five. 2. Strike price Gap- The various price gaps at which different option contract are opened for different underlying assets. 68
3. Time to expiration- A specified time, after which the options contract is no longer valid. The expiration time gives a more specific deadline to an options contract on top of the expiration date by giving a time of day. The expiration time was not be the same as the last time to trade the option. 4. Advance decline ratio- A market-breadth indicator to compare the number of stocks that closed higher with the number of stocks that closed lower than their previous day's closing prices. To calculate the advance/decline ratio, divide the number of advancing shares by the number of declining shares. The A/D ratio can be calculated for various time periods, such as one day, one week or one month. 5. Volatility Index- The Volatility Index is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. 6. Trade size- The number of shares being offered for trade at a specified bid price that a trader is wasting to trade at that bid price. 7. Put call Ratio- The put-call ratio is a ratio of put options to call options. The put-call ratio has long been viewed as an indicator of investor sentiment in the markets. Times where the number of traded call options outpaces the number of traded put options would signal a bullish sentiment and vice versa. 8. Type of spread- Spread refers to the difference between bid and asks prices of an asset. In an option spread refers to the purchase and sale of an option of the same class but of a different series. Type of spread refers to the spread created by call or put option. 69
9. Open Interest Ratios- Open interest is the total number of options and/or futures contracts that are not closed or delivered on a particular day. 10. Put call Trading Volume- It is the trading volume of the put options to the trading volume of the call options on a given trading day or period. 11. Volatility- Volatility measures the amount and speed at which price moves up and down, and is often based on changes in recent, historical prices in a trading instrument. Commonly, the higher the volatility, the riskier the security. 12. Greek letters- Greek Letters are special characters to measure the sensitivity of option prices. There are many factors affecting option prices. Each factor has a Greek letter associated with it. Such as Delta, Gamma, Theta, etc. 4.4.1.5. A Structured Questionnaire: Divided into 3 parts:- Part I-Common Questions for all analysts-section A Part II- Specific Questions for Option Spread Strategies ( Section B,C,D,E) and Part III-Demographic details of the Analysts-Section F It was of six sections-a, B, C, D, E, F and 11 pages consisting of 79 questions. Section A focuses on option strategies having 8 questions Section B on vertical spreads (Bull and Bear Spread) having 12 questions Section C on Stable Strategies having 3 subsections A (7), B (9) & C (9) having total 26 questions Section D on Volatile Strategies having 2 subsections A (7), B (10) having total 19 questions Section E-Open ended 2 Questions Section F- Demographics 12 questions. All the sections were same for both the type of analysts only section F was different. 70
4.4.1.5. B Type of Questions The questionnaire consist questions which were open-ended as well as closeended. The questions use various scales depending on the requirement. 4.5 SAMPLE DESIGN 4.5.1 Sampling Universe and Sample Unit The population for the study is the Derivative Research Analysts in the Indian Derivative Market. The accurate data regarding total number of such analysts in India is not available. In such scenario, the list of broking firms dealing in derivative markets of India was taken from the report of India s leading Equity Broking houses of 2013@. The list of 146 broking houses gave an overview of the major broking houses in India but the researcher selected those companies in which she could establish contact through references. Also these were not sufficient so 15-20 samples were selected through snowball sampling. The study was conducted on the Derivative Analysts in the derivative market of Ahmedabad and Mumbai for the following reasons:- The first reason being the western region of India having the highest number of broking companies, high number of terminals and high turnover * The second reason is that Ahmedabad holds the second position in western region in terms of maximum representation of terminals. The third reason being the easily accessibility of the respondents. @http://www.dnb.co.in/indiasleadingequitybrokinghouses2013/indias_leading_eq uity_broking_houses_2013.pdf * http://www.dnb.co.in/equitybroking2012/primary_insights.asp 4.5.2.2 Sampling Procedure: The samples are drawn using non-probability method of sampling. Further, the respondents need to be a user of the options in the derivative market and for this it can be 71
considered as purposive judgmental sampling method. The reason for adopting purposive judgmental sampling was decided on the following basis: The methodology of sample construction and data collection minimizes the risk of nonresponse bias being present. The method allows proper representation of the users of derivative products. The method allows the analyst restricted to option markets. The method incorporates the opinion of area experts. Also snowball sampling was be used where the respondents was be asked to identify other respondents who belong to target population where subsequent selection is based on referrals. 4.5.2.2 Sample Size: 80 Analysts in Total (Ahmedabad and Mumbai). There were 46 Individual Analyst and 34 Corporate Analysts. The sample was selected on convenience basis. Since the questionnaire was very technical and also in much depth (69 questions), utmost care was taken while selecting respondents so that respondents have adequate knowledge about the subject. In total responses of 80 analysts, 45 were collected through personal meetings, and rest was through telephones and e-mail. A google form was used to collect data through e-mails. Table 4.1 Breakup of Samples SR NAME OF INDIVIDUAL CORPORAT TOTAL NO. THE CITY ANALYST E ANALYST 1 Mumbai 9 9 18 2 Ahmedabad 37 25 62 46 34 80 4.6 PERIOD OF STUDY 1-04-2012 to 31-03-2015 1 September 2012 September 30 2013- Theoretical Construction of Strategies 72
October 2013-February 2015- Market Analysis of Strategies The trading strategies was be used for option market only with European Nifty Options as the underlying asset. 4.7 DATA ANALYSIS The first phase of the research is done through frequency analysis where all 79 questions for both the analysts in the questionnaire are analyzed using SPSS. The analysis gave the bird s eye view of the overall analysis. The questionnaire being very technical and of greater depth lead to the need of being each question reviewed individually where frequency analysis was best suitable. It was done with the help of SPSS and Excel 2010. There are various variables involved in creating option strategies. Factor analysis has been used to find the correlation among these variables and to group significant variables after reducing them. Factor analysis is done for both the type of analyst. Factor analysis showing more than 0.5 values in KMO test has been considered. 4.8 SCOPE OF THE STUDY A comprehensive literature review was carried to understand the trading strategies used in Indian Derivatives markets, Effectiveness of these trading strategies in option markets, parameters of option trading strategies and to address other research questions. The literature review was undertaken by referring to various papers and articles published by scholars in the field of finance, stock market, trading theory as well as books, online resources-ebsco & EMERALD, software-spss and newspapers. 4.9 SIGNIFICANCE OF THE RESEARCH The field of Trading in India with respect to derivative market is largely unexplored & there is not much research in this area especially in the Indian context. The findings of this study would help investors, traders, speculators, consultants, Analyst and Regulators 73
to better understand the anomalies in Indian Stock Market with respect to options in Derivative market. Specifically, the study would help address issues such as: Usage of Option Spread Strategies in other areas of the market like commodity market, precious metals & newly introduced currency derivatives. Selection of most appropriate parameter choices for option trading strategies. Understanding the market movements better using the option trading strategies arrived at in this study for different market outlooks. The trading strategies would be relevant to almost all the people interested in option markets. 4.10 LIMITATIONS OF STUDY 1. The study included questions that are confidential in nature. The respondents did not entertain the research if the researcher could not establish any personal reference. Hence, some companies could not be contacted under snowball sampling. Especially, corporate analysts could not be captured in more number in the study. 2. The study was restricted to two cities which can be explored in future research 3. The study was restricted to five types of option spread strategies which can be extended in future research. 4. All the respondents interviewed were not of the same hierarchy. They were contacted based on the reference given by the other respondents. Hence, this may have an impact on the responses given by them since they all worked at different levels in the organization. 5. The Indian Derivative market is still not organized fully. A large market exists through unorganized over the counter market which has not been captured in the study. 6. The study was restricted to the period selected for the study. So these have an impact on the responses of the study. 74
References 1. http://www.dnb.co.in/indiasleadingequitybrokinghouses2013/indias_leadin g_equity_broking_houses_2013.pdf 2. http://www.dnb.co.in/equitybroking2012/primary_insights.asp 3. Book on Marketing Research- An Applied Orientation by Naresh K. Malhotra and Satyabhushan Dash, Sixth Edition, Pearson Publication. 75