In “Are You Interested?” and “Still Interested?“, I described the importance and methods for watching open interest in derivatives such as options and futures. This information was demonstrated last week while I was teaching a Pro Trader course in Hyderabad. The class was able to watch live as the markets were manipulated to benefit traders of derivatives.
If you recall in the previous articles, I mentioned that when there is a large amount of open interest in a particular option, for instance the 5500 Nifty 23-Feburary-2012 Calls, there are a lot of people who sold those calls and they will only profit if the price of the Nifty closes below 5500. If the market closes above that level, those sellers lose money. The same happens for sellers of puts; the seller wants the prices to close above the strike price in order for them to avoid losses.
In an effort to profit from large option or futures positions, institutional traders will often buy or sell the underlying stock in an effort to push prices to a point where the close will benefit them. There is a term for this action, pinning. These traders attempt to pin the price of the stock, or the Nifty, to profit from a derivative position.
Pinning is illegal in most exchanges in the world and traders who participate in this high volume trading in an effort to manipulate prices could face penalties. The problem is in catching the culprit and SEBI punishing them. In an effort to prevent pinning, the exchanges have now established that the official closing price (which is used to calculate profit or loss for derivatives) is not the last traded price, but rather the average of all prices traded during the last 30 minutes of trading. It is assumed that it is harder to manipulate the average price than a last trade.
But does it really work? While we were in class on 23 February, we checked the open interest on the expiring options contracts for the Nifty. There was one crore of open interest on the 5400 puts with a large increase in the day. On the call side, the open interest was extremely high at 5500 and 5600. This meant that many traders would be happy with the closing price of the Nifty at expiration to be between 5500 and 5400.
There was a huge problem; the Nifty was showing strength after the open of the European markets and was trading above 5500. There was going to be a large loss for many traders. At 2:55 pm, I announced to the class to expect a large selloff in the next 20 minutes starting at 3 pm. As predicted, the institutions and operators promptly started to sell off the Nifty futures and large stock in order to push that average price below 5500.