How does short covering happen in nifty index?

Nifty & Bank Nifty discussions
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Shorting means expecting market to go down…
If after shorting, market shoots up, the people who are short will run to cover their positions(short covering)… i.e. to buy and square off their positions.

This in turn leads to more bullishness… (new buyers + people covering their existing short positions )

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The no-brainer and short answer is that whoever is short those calls will run to cover their positions and buy the call options at whatever insane price it is available. But this is only a consequence of the upmove in the nifty index not the cause of short covering.

To get a better understanding, you will need to dig deeper.

Some very basic guiding points that I can offer are below:

  1. A very rough assumption would be that institutions are long puts and short calls whereas the dealers are the counterparties with short puts and long calls.
  2. When the index witnesses significant upmove where these institutions would lose money on their short calls, they will want to move out of those positions.
  3. All of a sudden now with buying the underlying, there is new demand for long puts from these institutions which is met by the dealers. The dealers now have a payday on their long calls and move out of those positions as they need to hedge accordingly for the new book where they would have ended up selling higher puts to the institutions buying the index.
  4. The institutions now need to sell calls and the dealers buy those calls.

But all of this is mundane.

A more in-depth understanding of the institutional and dealer book is required to see where their hedging needs re-balancing. Sadly for us, we can only make a very rough assumption about this at best.

Let’s say you really did go down this rabbit-hole, you would then have a rough estimation of the gamma exposure of the dealers and the point where that gamma flips.

So, let’s say, that the dealers have a negative gamma exposure of Rs. X cr. Then in that case, the option dealers will need to sell Rs. X cr. worth of index for every 1% down move and vice-versa.

There’s a whole bunch more of theories that can keep you occupied and probably be of some help but almost always the simpler answer is the one that should be of more help here.

If you can spot a short covering move and you are able to ride that wave, does it really matter to you how the short covering was triggered or who had to re-balance their books and at what point and at what cost?

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@joyesh Thank for the explaination and your effort.

When the institutions are exiting their short calls there is no activity happening from them in the equity space right?(Like buying the stocks).So y will index move up without buying in stocks.
Institues are covering their positions in Derivatives market and not in equity market.So how will the Index move up without huge activity in equity from those institutions covering their positions in options.

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Ask yourself why will institutions cover their existing short calls in the first place.

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@joyesh Yes they might be incurring loss in their call writing as the nifty breaches the strike price on upper side.
When they are covering the short calls there in no activity happening in equity from these institutions right?Then why will their covering of short calls move the index more higher?

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Could it not be that they are the ones buying the underlying to begin with?

Why would you assume this?

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@joyesh Thanks for helping me build a stronger conviction.
And another thing is Can the institutions hold short positions in stocks for more than 1 day?

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As I know that in India, the Securities and Exchange Board of India (SEBI) allows traders to short sell equity only in intraday trade. So, your borrowing duration from your broker will be of one day only so how can institutions keep their short positions open for more than one day

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elaborate please

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does it mean, they move index through buying in equity, but there is not enough institutional volume in it

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       i want to know how things work at depth
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@Lalit_Kishor what i wanted to convey was as there was no buying happening in equity market why will the index go up?

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even i want to know same

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One can create short position in futures and hold it upto monthly expiry. The equity price will follow since arbitragers will jump the wagon to match the equity and futures pricing (shorting futures and buying same qty underlying to benefit from the difference)

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There is something called arbitrage wherein if Futures is trading at a premium compared to spot price (take eg. ITC Fut is Rs.230 and ITC cash is Rs 228).

Now the lot size of ITC Futures is 3200. That means you short 1 lot (3200qty) at Rs.230 and buy 3200 qty in cash market at Rs. 228.

At expiry, the Spot price = Future price. So you get the profit of Rs. 2 x 3200 = 6,400 per lot.

Thats what arbitragers do to benefit the price difference and theoretically spot should influence the derivatives price but directly or indirectly derivatives has an effect on the spot price since most of the trading activities happens in FnO segment.

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In cash market, no.

In derivatives, yes!

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Hi Nidal, How does this pair trading work with index like Nifty? One can short futures but how do they buy it? Is it through buying the underlying equities?
I am still not clear on the question asked above on the index spot movement due to short covering in options. Index spot is ultimately the calculated value based on all its constituents. So why would it move due to supply-demand changes in derivative space.

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Hi @jmanish

Some of that doubt was cleared to me by @nithin . Please check this post:

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Thanks @Nidal for a quick response. This other post and answer by @nithin clarifies few things.

So let me summarize what I understood:

  • Speculation/hedging leads to change in call or put option pricing
  • This in turn effects future pricing given the formula (Futures Price = Strike + Call Price – Put Price)
  • This leads to arbitrage opportunities between spot and future price differential
  • Big players use this opportunity and impact the spot price by selling/buying the underlying equities (all of them or the top few). This is how we see index spot moving
  • As an example, during short covering, call option price shoots up thus increasing the future price. Arbitrage gets created and people short sell future and buy underlying spot.

Did I get this right?
I mean seriously, identifying this kind of arbitrage and acting upon it is possible for big institutional players only.

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When we have a strong clue about decline of price of stock, then we sell a stock from portfolio to the broker and after this price decline and we rebuy same stock in same amount but we have to pay somewhat low, it happen when we want close an open short position.