Since the introduction of the Closing Auction Session (CAS) for Futures & Options (F&O) stocks, the last 15 minutes of the trading day have been highly volatile in the Indian stock markets. Since the new system came into effect on 3 August 2006, the gap between the closing of the market at 3:15 pm and the actual closing of the stock has been huge and traders have been baffled.
While the move is intended to increase transparency and price discovery, the beginning has brought extreme end-of-day swings to benchmark indices such as the Nifty 50. Here’s all you need to know.
What Is the Closing Auction Session?
After normal trading hours, a ‘Closing Auction Session’ is conducted for all eligible F&O stocks. Rather than setting the closing price on the basis of prior day’s VWAP, the exchanges gather buy and sell orders during a specified auction time and arrive at a solitary equilibrium price where these buy and sell orders can be matched in the largest possible numbers.
The new mechanism is designed to:
Improve price discovery
Reduce last-minute price manipulation
Increase transparency
Bring Indian markets at par with international standards
Why Is the Market Witnessing Sharp Swings?
In a few trading sessions with this new system, some issues can already be observed.
1. Different Closing Prices Than Continuous Trading
In the previous system, investors regarded the 3:30 pm price as market closing. However, on the new system, prices are derived from the auction process, which has led to significant variance in closing levels.
For example, during the first two sessions:
Nifty’s official close was nearly 0.8% higher than the continuous market close for the first day.
The session further below also had a 0.6% difference.
Those unanticipated differences shocked retail traders as well as institutional traders.
2. Weekly F&O Expiry Increased Volatility
The effect was even greater as the new system coincided with the weekly derivatives expiry.
Because of the fact that both the futures and options settlement prices are determined by the officially announced closing price, a fairly subtle change during the auction has a large impact on:
Option premiums
Futures settlement
Arbitrage positions
Index-based trades
Some traders were surprised by some of their profits or losses due to the settlement prices changing so suddenly.
3. Limited Visibility During Auction
Unlike in continuous trading, investors are unable to constantly observe the developments in auction prices.
Because of this opacity, traders face with uncertainty, in particular those who tend to shift positions from day to day.
Why Did Nifty and Sensex Move Differently?
Yet another big point of discussion has been the extraordinary divergence in India’s two key indices.
The Nifty reflected much sharper movements in the end of day due to the fact that the F&O stocks comprising the index were impacted because of the new auction process. The other key index, the Sensex, differed in behavior because of differences in index composition as well as trade activity specific to the exchange.
Given the total unknowns, experts suggest this difference will eventually go away as market participants adjust.
Benefits of the Closing Auction Session
While the initial volatility seems worryingly high, market specialists believe the new system has multiple long-term benefits.
Better Price Discovery
Here the auction ensures that all open buy and sell orders are employed in settling a reasonable market close price, instead of using only the most recent few trades.
Reduced Price Manipulation
A structured auction prevents a small number of large bids from being able to manipulate closes.
Stronger Market Integrity
Institutional investors, mutual funds, and ETFs often use official closing price for valuation and settlement. Transparent pricing process enhances confidence in benchmark prices.
Alignment With Global Markets
Numerous developed exchanges across the globe already employ auction-like closing procedures which might be very useful.
Why Are Traders Concerned?
However, there are still issues associated with them.
Higher short-term volatility
Increased uncertainty during derivatives expiry
Difficulty in predicting settlement prices
Cash-futures temporary mismatch.
Retail investors are still adjusting to the revised regulations.
Some active traders tend to think that until there is a more active participation in the auction, the continuing transition period will be very volatile.
Will SEBI Review the New System?
As per recent reports,SEBI does not intend to have an immediate review of the Closing Auction Session.
The regulator feels the market requires a little more time to settle and expects that the number of buyers and sellers will increase in the upcoming weeks. The authorities feel that the greater the number of investors the better will be the price discovery and the lower will be the volatility.
What Should Investors Do?
Long-term investors should not be reacting to price swings which occur at the close of trading.
Instead:
Concentrate on company basics.
Be cautious not to let auction price movements influence your emotions and lead to hasty trading decisions.
Keep in mind that the official settlement prices are different from the continuous prices.
Understand the functioning of auction process before trading in F&O contracts.
The significance of the Closing Auction Session is more important to derivatives traders, since settlement on the Exchange now depends on auction-discovered prices instead of VWAP.
Final Thoughts
The introduction of the Closing Auction Session (CAS) is one of the most significant structural changes India’s equity markets has seen in recent years. Although the initial few sessions have created tumultuous swings and created confusion among traders, the new system aims to bring about better price discovery, transparency and integrity in the markets in the long run.
With time and as liquidity picks up during the auction window, the experts expect volatility to subside. In the meantime, investors should stay alert, not panic over temporary price swings, and get educated on the implications of the new closing mechanism on stock and derivatives markets.
