Mkt regulator Sebi mulls options to future switch for single stocks

Move, akin to commodities futures, to ease risk around physical settlement

The Securities and Exchange Board of India (Sebi) is working on a proposal to convert single stock options into futures contracts a day before expiry.

 

The proposal — on the lines of the model followed in the commodities market — is aimed at mitigating risk around physical settlement and payment of margins.

 

For the derivatives segment, all stock derivatives positions on the day of expiry have to be compulsorily physically settled. Market players said this potentially leads to systematic risk when out-of-the-money options suddenly turn into in-the-money on expiry day. When that happens, the option holder has to honour the physical settlement.

 

“If the position is large enough, then there could be potential risk that the option holders fail to bring in the cash or securities to honour the settlement,” said an expert.

 

Under the proposal, all in-the-money options on the underlying stocks will be converted into futures contracts of the same underlying on the day prior to expiry (E-1). As a result, on expiry day, only futures trading will be allowed in single stocks.

 

The resultant stock futures positions can be closed on expiry day or may be settled by delivery.

 

An email sent to Sebi seeking confirmation of the proposal went unanswered.

 

On E-1, all long call or long put options will devolve into long or short positions, respectively, in the underlying future contracts. Likewise, all short call or short put positions will devolve into short or long positions, respectively.

 

Currently, clearing corporations impose delivery margins in a staggered manner — with margin requirements going up as expiry nears. The new system won’t necessitate any change in the margin system and will also keep volatility in check.

 

“The margin requirements are higher for traders holding the position till the end. Last day of the expiry, the margin requirement is the highest. Brokers also force their clients to square off their positions before expiry. The proposal to convert options into futures ahead of expiry will help address the margin issued and also help reduce volatility. Exchanges want to reduce the excessive volatility seen on the expiry day,” said Chandan Taparia, head - technical & derivatives research, Motilal Oswal.

 

In the commodities segment, all the in-the-money options are converted into a futures contract at the strike price if they are not exited before the commencement of the tender delivery period.

 

In August 2017, stock exchanges had introduced the “Do not exercise (DNE)” framework for cash settled stock options. DNE was to avoid traders having negative pay off as the securities transaction tax (STT) had to be paid on notional value of contracts. Later in 2019, STT was rationalised and levied on the intrinsic value of the option. In 2021, DNE was discontinued as concerns related to negative pay off were no longer relevant.    Brief History  

Stock exchanges introduced do-not-exercise (DNE) framework in 2017   

The move was to avoid negative payoffs as securities transaction tax (STT) had to be paid on notional value   

STT rationalised in 2019, levied on the intrinsic value of the option   

Exchanges discontinued DNE in 2021   

Sebi mulls converting single stock options into futures a day ahead of expiry