How Sebi's seven proposals for index derivatives could affect traders

A lot of revenue gets generated for brokers, exchanges and government with expiries and removal of these expiries could result in a decent drop in their revenue.

ASHISH GUPTA

The capital markets regulator, the Securities and Exchange Board of India (Sebi), recently released a consultation paper with regards to derivatives trading and the heightened volatility in markets, owing to the increased participation in F&O (futures & options) trading.

There were many recommendations in the July 30 paper. Let’s look at each one of them and their implications for traders.

1. Rationalisation of strike prices for options: According to the paper, it is observed that there is a massive increase in retail participation in OTM (out of the money) options on expiry days. Hence, the paper seeks to reduce the number of strike prices.

If we consider Nifty as an example, which is currently trading at 25000, from 24500 to 25500 (4 percent), the strike price should be at an interval of 50. As we move further from 4 percent to 8 percent, the interval should be 100. Also, it is proposed that not more than 50 strikes should be available. So this means that, at any given point of time, the strikes available could cover roughly about 8-10 percent on either side.

Also read: Sebi unveils measures to check front running, insider trading at mutual funds

Implication: While the observation is right, the reason for participation in far OTM options on expiry days is that a lot of traders run algo-based strategies where they sell near ATM options and buy far OTM options as a hedge to get the margin benefit.

The reduced number of strikes may not have a larger impact on day-to-day trading, but an intraday Black Swan event, when far OTM strikes quickly become close to money, could lead to all sorts of troubles. For example, traders may not have further strikes to hedge/trade.

How quickly the NSE launches the newer strikes and brokers make them available on a day like this would be something to be seen. From personal experience, I can say a lot of brokers won't be able to come up with the newly introduced strikes during intraday, in case a stock makes quite a big move.

2. Upfront collection of premiums: This is what the paper says: there is a stipulation for upfront collection of margin for futures (both long and short) as well as options buying. This already exists.

The collateral that one places in the form of stocks, FD, mutual funds or Bees can only be used for option selling and not for buying. Most brokers I have worked with do collect option buying premium in cash. Is there a violation of this rule being observed and that’s why this recommendation is being made? If yes, this proposal should further strengthen the rule and would mandate all brokers to follow it.

Implication: Not much on traders.

3.Removal of calendar spread benefit on expiry day: Calendar spreads are trades involving two different expiries of the same underlying. The margin reduces if you have a sell option trade in one expiry and a buy in another (same side, i.e., either call or put or both in two expiries). It is proposed that margin benefit should not be available, if it is a contract expiring on the same day. The reason given is that the derivative value for the expiring contract can move very differently from the derivative value on the far-month expiry.

Implication: This doesn’t make a lot of sense to me because we won’t see Nifty trading, on any given expiry day, way off the next-month expiry. There is usually half a percent divergence between the current month contract and the next month contract, when there is a whole month to the next expiry because of the cost of carry.

Any further significant divergence to this will present arbitrage opportunities. For this reason, it might not stay that way for too long. Consider this: the Nifty is trading at 25000 and if you sell a naked call option of 25000, it would require about Rs 75k .

However, if you buy a 25000 call option of the next month expiry, the margin would come down to about Rs 25k. Let’s take a hypothetical case where Nifty moves 2 percent higher but the next month's futures contract still trades at 25000 (highly unlikely).

This means the sold option contract would lose about Rs 12,500 and the upfront margin collected still covers that very well. If the reasoning to disallow margin benefit on expiry day is to discourage the increased participation on that day, it would have made much more sense to me. Probably instead of completely removing the margin benefit, reducing the margin benefit would have been a good first step.

4. Intraday position limits: Position limits for various participants/ product types are specified by Sebi. These limits are monitored by Market Infrastructure Institutions (MIIs), like Clearing Corporations and Stock Exchanges, at the end of the day. The new proposal is to monitor and ensure it on an intraday basis as well. It was a loophole that allowed brokers to breach the position limits on an intraday basis but this will now ensure that position limits are maintained by all brokers even during intraday.

Implication: Currently, brokers don’t allow you to take overnight positions in such strikes that one could take intraday only. With this new proposal, they will have to restrict intraday positions too. This step might actually bring volumes down, in my opinion.

5.Minimum contract size: The current contract size for most underlyings (indices as well as stocks) are about Rs 5-10 lakh, while some stocks are more than Rs 10 lakh. This gets revised periodically and is brought down. It is proposed to increase the contract size for index derivatives in two phases:

a) Minimum contract value to be between Rs 15-20 lakh at the time of introduction
b) After 6 months, it will be revised to Rs 20-30lakh.

Implication: With increased lot sizes, the margin to trade a single contract would increase. For options buyers also, the premium required to buy one lot of a call or a put option would increase. This step, in all likelihood, would affect retail traders with a small capital of, say Rs 1-2 lakh. However, whether this will this be further extended to stock options and how that would impact liquidity in stock options, which is already thin for a lot of them, is to be seen.

6.Rationalisation of weekly index options: Currently, there is everyday expiry. In fact, there are two expiries on Monday -- Bankex and Midcap Nifty. All these have happened in the last year or two only. Previously, there used to be just Nifty and Bank Nifty weekly expiries. Now it is being proposed that each exchange should offer just one weekly expiry -- one for the NSE and one for the BSE. The reasoning given is to bring market stability and avoid the huge intraday volatility that is being seen, of late.

Implication: A lot of changes have been carried out in the last few years -- be it removal of broker level leverage, introduction of weekly expiries, shifting of expiries in order to accommodate both the NSE and the BSE, everyday expiry, etc. Traders have adapted themselves to all such changes.

With the introduction of daily expiries, a lot of traders have completely changed their style of trading and are only doing intraday DTE (days to expiration) trading. They will again have to adapt to this change.

Though, at a broader level, this is a welcome change, in my opinion, since it will help reduce intraday volatility that has been observed due to a large number of traders actively doing 0 DTE (zero days to expiration) trading, it will be interesting to see if this gets implemented. A lot of revenue gets generated for brokers, exchanges and the government from these everyday expiries. Their removal, obviously, could lead to a drop in revenues.

7.Increased margin for near-contract expiry - ELM (extreme loss margin) will be increased by 3 percent on a day prior to expiry and by a further 5 percent on expiry day. This is to add a further cushion in case of a sudden Black Swan event, intraday.

Implication: While the idea is good, the increase in margin is not significant in my opinion. Let’s say if it requires you to have Rs 1 lakh margin for a given position, it would now require Rs 1.08 lakh on expiry day for the same position. The change is not substantial to create any major impact on traders.

End Note

Retail participation in intraday options trading on expiry days has certainly grown multifold. Most retail traders are running a similar set of strategies that involves selling ATM options and buying far OTM as hedge. Given the volume, this makes the OI (open interest) heavily concentrated at ATM and near-ATM strikes.

Intraday volatility and sudden 50-100 points move in the Nifty and similar moves in other indices on expiry day in recent weeks are mostly due to people running such strategies, in my opinion. So, the concerns raised in Sebi's consultation paper are all valid and need to be addressed. Although I may not agree with some of the proposed changes, it’s a good first step in order to reduce the crazy retail participation during expiry days.

(The writer is a Singapore-based independent derivatives trader.)