Hedge Funds Raise Concerns Over Options Market Manipulation, Seek SEBI Intervention

Fund managers have informed SEBI, the market regulator, that they suspect manipulation in the derivatives segment, potentially involving a major player. These fund managers, who oversee substantial assets both in India and internationally, have not identified any specific names but claim to have noticed unusual trading patterns. They warn that if these activities persist without intervention, they will significantly reduce their exposure.

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According to sources, SEBI is currently reviewing the complaints but has yet to find concrete evidence of manipulation. The investigation remains ongoing.

To support their allegations, market participants highlight the following example:

• February 1, 3:30 PM, Sensex: 77,506; Price of Sensex 77,500 call (4th Feb Expiry): ₹300.
• February 4, 1:30 PM, Sensex: 78,277; Price of Sensex 78,300 ATM call (4th Feb Expiry): ₹319.45.

They argue that the pricing of these options should have differed significantly due to varying levels of uncertainty. February 1, being the day of the Union Budget presentation, was three days before expiry, a period that typically brings heightened uncertainty and higher option prices. February 4, in contrast, was an uneventful expiry day with only two hours left before expiry—factors that should lead to lower uncertainty and cheaper options. However, the prices remained almost identical.

"It's akin to betting on a horse race where one horse is 500 meters from the finish line while another is just 5 meters away, yet both are being priced with the same uncertainty," a source explained.

Experienced fund managers, some with decades of expertise in options trading—one of whom has consistently delivered 40% returns with a mere 5% drawdown over nearly a decade—told Moneycontrol that they, along with many peers, believe a large fund or a group of funds may be manipulating India's derivatives market.

While many fund managers have suffered due to these activities, some have managed to adapt by predicting the suspect entities' moves and adjusting their strategies accordingly. However, a fund manager whose returns have remained unaffected pointed out that their primary concern is not profitability but the overall integrity of India’s securities market, which could be at risk.

What is the alleged anomaly?

Ordinarily, derivative prices fluctuate based on the movement or expected movement of the underlying asset, in this case, the index. However, fund managers claim that in India, things appear to be reversed—sharp price swings in derivatives often precede corresponding movements in the underlying asset, seemingly justifying the prior changes in option prices.

This phenomenon has led to what they call "violent expiry days." "On these days, implied volatility (IV) of options spikes dramatically from 12% to 36% without any fundamental reason—it’s beyond a 3-sigma event, which is statistically improbable," said one fund manager, requesting anonymity.

Implied volatility (IV) reflects the market’s expectations of price fluctuations in the underlying asset (Nifty/Sensex), while sigma represents standard deviation. A 3-sigma event should statistically occur only once every 300 trading days. However, fund managers claim that such extreme volatility has been occurring regularly on expiry days.

"Someone is clearly accumulating options in large volumes, driving prices up, and then influencing the underlying market to extract disproportionate gains," a fund manager explained.

This could be achieved through trades in the cash market, but fund managers believe the manipulation is more likely happening via synthetic futures or deep in-the-money (ITM) options to move the underlying asset’s price.

For example, fund managers highlight the ATM call + ATM put prices for Sensex expiry on February 4. Normally, option prices decline as expiry approaches due to reduced uncertainty. However, in this case, ATM straddle prices remained elevated until 1:30 PM on expiry day, followed by a sharp 1.81% movement in the Sensex.

Just as there are violent expiry days, there are also quiet expiry days—days when option premiums are unusually low, followed by an eerily stable index performance, even as other indices display significant movement. Quiet days primarily benefit option sellers.

Has SEBI’s intervention helped?

On October 1, 2024, SEBI introduced new regulations aimed at curbing speculative activity in index derivatives. Weekly expiry contracts were reduced to two per week per exchange.

However, according to Dhruv, this has not mitigated the risk—if anything, it has intensified the problem.

"Traders now fear the manipulator, making them hesitant to sell options. This has reduced liquidity, forcing the manipulator to buy at even higher prices. As a result, they must now push the underlying index even harder to profit from their positions," Dhruv explained.

"We have drastically cut back on expiry-day trading because predicting the nature of an expiry has become nearly impossible. Instead, we focus on monthly contracts, where gamma risk is lower. We’ve also reduced our overall exposure to derivatives by 50%."

Notably, some of the biggest expiry-day market moves have occurred after SEBI’s new rules were implemented.