Mad rush to cover short-positions puts futures traders in a corner

http://economictimes.indiatimes.com/articleshow/5040304.cms

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People familiar with the matter said most of such synthetic long positions were created between 4800 and 4900, as proprietary traders saw anomalies in the implied volatility (premium pricing) between two strikes of the Nifty options. The options trading strategy involves the risk of unlimited loss, as it involves selling an option. An example of such a trade, a trader sold the Nifty 4800 September ‘put’ options in return of a premium of Rs 122 per contract and bought the Nifty 4900 September ‘call’ option for Rs 78. The net credit for both the trades is Rs 44 per contract.

Simultaneously, the trader sold the Nifty futures at 4850, as a hedge against the options positions. The extent of hedge needed, through the Nifty futures, was 70-80% of every one lakh options worth of open interest. Now, in the options trade, the break-even is at 4844 (strike of 4800+ premium 44), while the Nifty futures was sold at 4850. The difference between the synthetic long futures and the Nifty futures fetched a neat profit of Rs 6 (4850-4844), at the point of creating the strategy. The trader needs this difference to shrink from Rs 6 to nil on expiry of the September series, to pocket this amount.

This is where the calculations of these traders went wrong. As the Nifty rose further to 5000, the difference between the synthetic long futures and the Nifty futures started expanding. To keep up with the market’s rise and satiate the need for more hedging, as per the 0.70:1 futures to options position ratio estimates, traders added more short positions of the Nifty futures, causing their transaction costs to shoot up.
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