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Informist, Friday, Dec. 27, 2024

 

By Rajesh Gajra

 

NEW DELHI - The Securities and Exchange Board of India is not keen to take forward the proposal made in a recent consultation paper to devolve stock options into stock futures one day before the expiry as the proposal is weak on merit, a senior official in the market regulator told Informist. The idea emanated from outside the SEBI and not internally, the official said.

 

In a consultation paper on Dec. 5, SEBI proposed a framework to convert in-the-money stock options into futures contracts a day before the expiry. The market regulator issued the consultation paper only because it got a strong representation from the industry standards forum of intermediaries to change the rules, the official said. The only proposal in the paper was to introduce a framework to allow devolvement of in-the-money stock option contracts into stock futures contracts, one day prior to expiry.

 

An in-the-money call option is one whose strike price is below the spot price of the underlying, while an in-the-money put option is one whose strike price is above the spot price. As per current rules, on the expiry day, all in-the-money stock options based on the volume-weighted average price in the last 30 minutes are automatically exercised and converted into underlying deliverable obligation since stock derivatives, unlike index derivatives, are settled by delivery and not cash.

 

The industry standards forum of intermediaries, constituted by SEBI, proposed that in-the-money options should not result in the physical delivery obligation to prevent the risk of an out-of-the-money contract turning into an in-the-money one after market hours, either due to a favourable volume-weighted average price or due to sharp changes in the price of the underlying in the last 15 minutes of trade. A member of the industry standards forum told Informist that this demand was raised because when an out-of-the-money contract turns into an in-the-money one, the option buyer has to borrow a huge amount of money or a large quantity of shares to take or give delivery of the underlying stock without having an opportunity to square off the position.

 

The SEBI official, who did not wish to be named, said the market regulator was not keen on the proposal due to the lack of compelling data and the use of a theoretical systemic risk that could be resolved by other means. The data is not compelling because when SEBI looked at the data for six months from April to September from the National Stock Exchange of India, it found that there was no instance of an out-of-the-money stock options contract turning into an in-the-money one based on the settlement price as determined by the volume-weighted average price of the last 30 minutes.

 

Further, in the last 15 minutes on the day of expiry, there were only 10 stock options contracts which turned into in-the-money from out-of-the-money. According to the official, since there were only a few cases, the number of affected investors was few and the only risk is a theoretical one of this risk metamorphosing into a system-wide risk.

 

The market regulator may look at alternate suggestions. For instance, it may look into whether imposing delivery margins on all out-of-the-money contracts, which are not levied currently, will adequately plug the theoretical risk. A delivery margin is currently imposed on all in-the-money stock options contracts.

 

Devolvement of options into futures has been applied in India and internationally in derivatives contracts on large or high-volume physical commodities such as crude oil and natural gas. In the Indian commodity derivatives market, apart from futures contracts on crude oil and natural gas, there are options on futures contracts on the two commodities.

 

The underlying for crude oil and natural gas options on futures contracts are the futures contracts on crude oil and natural gas and not the actual commodity itself. This is different from crude oil and natural gas futures contracts, where the price discovery is linked to the spot prices of the two commodities. But, unlike in the equity derivatives segment, these two commodity futures contracts are settled in cash, and not through delivery.

 

On the Multi Commodity Exchange of India, the devolvement of crude oil and natural gas options on futures contracts takes place two days before the expiry of the underlying futures contracts. All open long call positions on the option on futures contracts devolve into long positions in underlying futures contracts, while short call options devolve into short futures. Similarly, long put options devolve into short futures, and short put options devolve into long futures.

 

The same mechanism of devolvement is proposed in the SEBI paper on all in-the-money equity stock options. The last date for receiving public feedback on SEBI's consultation paper was Thursday. While SEBI will give weight to public feedback in favour of the proposal, it reserves the right to take an opposite stance if, in its view, the compulsion and merit are lacking, the official said.  End

 

Edited by Saji George Titus

 

 

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