India options trading drops 27% as new auction upends strategies

India's options trading volume has dropped by 27% following the introduction of a new closing auction mechanism, as traders adapt to one of the country's most significant market-structure changes in recent years. Average traded volumes fell to 268 million contracts for the August 4 and August 11 expiries, compared to about 369 million contracts on average in July, according to Bloomberg data.

The decline underscores the impact of the new price-setting system, particularly around derivatives expiry, one of the market's busiest days. Some traders are reducing their activities or adjusting their trades due to sharp price movements during the auction's initial days, making it challenging to buy and sell at expected prices.

Despite a recent easing of these swings, traders are still grappling with how to adjust to the change. Many proprietary trading firms and high-frequency traders, crucial for providing liquidity on expiry days, either avoided the auction or reduced activity during the first few days. The thin liquidity caused significantly larger moves in the equilibrium price than traders were accustomed to before the system was implemented on August 3.

The official closing price is used for index funds, passive portfolios, and derivatives settlement, making these price swings highly significant. This disruption occurs at a time when activity in India's derivatives market is already slowing. Notional volumes reached a 17-month low in July following the central bank's tightening of funding rules for proprietary traders and stock brokers, part of a series of regulatory measures aimed at curbing excessive speculation.