All you need to know about inclusion/exclusion of stocks in F&O segment

On Monday, National Stock Exchange (NSE) announced exclusion of four scrips - Dish TV, Tata Motors DVR, NBCC and Castrol India from the futures & options (F&O)/derivatives segment. The exchange, in its circular, added that the existing unexpired contracts of expiry months November 2019, December 2019 and January 2020 would continue to be available for trading till their respective expiry and new strikes would also be introduced in the existing contract months. However, no contracts shall be available for trading in these shares with effect from January 31, 2020.

Let's delve deeper and find out why NSE excluded these four scrips, what are the criteria for the inclusion and exclusion of securities in the F&O segment, what does the exclusion signify and what's the takeaway for investors/traders.

A quick brief on F&O segment

There are two segments of stock markets - cash and F&O/derivatives. Cash segment refers to buying/selling of shares at the current market price whereas in F&O market, there is an agreement between the two parties to buy/sell the scrips on a future date for a price mutually agreed upon while signing the contract.

A futures contract is a contract where the agreement takes place via a regulated exchange (such as BSE, NSE). Options contracts give the right but not an obligation to buy or sell the underlying asset at the stated date and price, known as ‘strike price'.

Derivatives, in simple terms, means the financial instruments which derive their value from the underlying assets. For example, the underlying assets could be indices such as Nifty, Sensex, Bank Nifty and select stocks in the cash market.

Benefit of F&O

Since you are not holding the stock, you won't get any dividend. Then, why would you enter the segment?

The idea was to allow such kind of an activity by paying less. Suppose, you want to buy a stock for Rs 5 lakh. So, for cash segment you need to pump entire Rs 5 lakh to buy the stock. However, in derivative space, say the margin collection is 20 per cent, then by paying Rs 1 lakh, you can hold the stock worth Rs 5 lakh.

So, whatever price action happens - whether benefit or other way round, it is being credited/debited to your account. This was the incentive given to the trader/investor to increase liquidity of the stock of the company.

How stocks get introduced in F&O space

Securities and Exchange Board of India (Sebi), the capital markets regulator, has laid down a few criteria for the introduction of stocks in derivatives segment. They are as follows -

• The stock shall be chosen from amongst the top 500 stocks in terms of average daily market capitalisation and average daily traded value in the previous six months on a rolling basis. 
• The stock’s median quarter sigma order size (MQSO) over the last six months, on a rolling basis, shall not be less than Rs 25 lakh. Median quarter sigma order size means the order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation. Simply put, it means the order size which is required to have an impact on the stock price.  
• The market wide position limit in the stock shall not be less than Rs 500 crore on a rolling basis. This, basically, refers to liquidity in terms of market wide position limit. This means whether the stock is the cornered stock i.e. held and traded by few people or it is a widely traded stock.
• Average daily delivery value in the cash market shall not be less than Rs 10 crore in the previous six months on a rolling basis.

These criteria are to be met for a continuous period of six months.

Why stocks get excluded from F&O space

If a stock is not in conformity with any of the above-mentioned criteria, the exchange removes it from the segment. If the stock has become such that with a lesser amount of investment, there is an impact on the stock price then it means that the liquidity in the stock is below the defined criteria and hence not fit for derivatives trading, explains Sahaj Agrawal, Head of Derivatives at Kotak Securities.

"Such stocks would not be appreciated in the F&O space as there is a chance of unwarranted speculation in the same. Of course, the premise of trading is volatility but high impact cost/low liquidity would increase risk for the trader significantly,” Agrawal added.

Hence, to protect the interests of common investors, to keep the market transparent, and to ensure there is no speculative trading on the stock via manipulation by a certain set of people, NSE bans the scrip from F&O market.

Should investors in cash market be worried on F&O exclusion?

Exclusion of stocks from the derivative space doesn't speak good about the companies and hence investors are advised to reassess and revisit their portfolio, says Dharmesh Kant, Head - Retail Research at IndiaNivesh Securities.

Citing an example of Indian Bank, which was in the derivative space around 18 months ago, Kant said that the stock price plummeted after its exclusion from the segment and the fundamentals of the company have also deteriorated to a great extent.  Hence, "revisit the rationale for which you bought the stock. If you are still satisfied, you can continue to hold," the analyst says.