Options were introduced in the Indian stock markets in the year 2001(the index options in June and individual stock options in July). There has been considerable increase in the volumes of trading in these derivative instruments since then. Volatility is the most important input in the pricing of an option. For a sophisticated trader, option trading is volatility trading and the trader who can forecast volatility the best is the most successful trader. Since options have been introduced only in 2001, it is interesting to study the degree of sophistication attained by the participants of options markets in India during the past three years. The present study attempts to compare the ability of the market participants in forecasting volatility during each one of the years. Using the data on prices of stocks and options of selected scrips as well as the index (Nifty) during the three years 2001-02, 2002-03 and 2003-04 (July-June), implied and realized volatilities have been calculated and compared. Closer the implied volatility to the realized volatility, better the forecasting ability of market participants. Although the study could not establish that the markets have improved in their forecasting ability of volatility, it has shown that the predicting capability of the market has increased in the case of several stocks during the period 2001-04. As far as the forecasting capability of the index is concerned, it has positively improved. The markets seem to be able to forecast the volatility better in the case of those stocks, whose options have a higher turnover. The study has also shown that the predicting power is better in the case of those stocks whose volatility is high.

While futures do help in hedging against the adverse price movements, they do not help in taking advantage of favorable price movements. Options provide this facility as the holder has the right to either exercise or not exercise the option, depending upon the prevailing situation; she will exercise the option only when it is advantageous to her. In view of this feature of options, the pricing of options becomes a more complex phenomenon. It not only requires skills relating to financial mathematics but also good forecasting capabilities.

It is interesting to study the abilities of the participants of option markets in assessing the future trends of important indicators like volatility for pricing options. It becomes all the more interesting to study the same during the introductory stages of options in a market. Options have been introduced in the Indian stock markets during 2001, and the present study attempts to compare the forecasting abilities of market participants since the introduction of options. The study is organized into four Sections. While Section II presents the trends in options trading in Indian stock markets, Section III details the data and methodology used in the study. The Results are discussed in Section IV, followed by the conclusions in Section V.