MC Explains: How SEBI may improve risk-measurement in options trading

What is the present system?

The regulator has several means to ensure that the risk investors take isn’t heavy on them and isn’t disruptive to the market’s integrity. One of them is to place a market-wide position limit (MWPL).

MWPL is an upper limit placed on the open interest - which is the number of outstanding derivative (futures and options) contracts—in any asset such as a stock. This limit is set as a percentage of the free-float of a stock or the portion of company’s shares that have been made available to the public; in India it is set at 20 percent of the free float. This is because the regulator prefers that the volume in the derivatives market is in sync with the volumes in the cash market.

If they are out of sync, it could lead to excessive trading or speculation in one stock or index or any asset, which if unchecked could lead to price manipulation, volatility, and market instability.

If the MWPL is reached, then there a ban on trading in the stock, except for squaring off or exiting existing positions. This ban mechanism can be hijacked by people who are looking to stop fair price discovery of a stock, according to insiders. For example, if someone wants to ringfence a stock, to stop its price from falling due to a negative event or announcement, the person could get operators to trade illiquid options in the stock to cause the stock to hit its MWPL and to cause a ban in the trading of the stock.

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So what is the flaw in the current system?

According to the WTM, the way open interest (OI) is measured to capture market risk currently may be flawed.

Currently, total OI is captured through notional OI, which is got by multiplying OI (or the number of contracts) with the underlying asset’s price and the contract multiplier. Therefore, every derivative contract—whether it is futures or options contract—will have a risk-multiplier of one. Or, that one contract equals one unit of risk that an investor is exposed to.

But, as Narayan pointed out, adding OI across futures and options (to capture the total OI) is like adding apples and oranges. 

A market insider explained: The risk that an investor is exposed to by holding a futures contract may be captured with a multiplier of one but the risk that an investor is exposed to when holding an option contract needs to be captured by considering the option’s delta. Delta is a measure for the sensitivity of the option’s price (called option premium) to the underlying asset.

If the price of the stock goes up by X amount, the price of a futures contract also goes up by approximately that amount. But the price of an options contract only changes to the extent of its delta.

For example, if the price of stock goes up by X, then price of an at-the-money (ATM) option with a delta 0.5 will only move by 0.5 multiplied by X and not by X.

This means that the investor only needs to cover to that extent of the risk.

Therefore, adding up all the contracts with equal weightage to get a measure of the risk is flawed,  or as Narayan said, like adding apples and oranges.

Therefore, the regulator is considering transitioning from notional OI to Delta OI.

What is Delta OI?

It is a delta-weighted risk exposure of options contract. It is calculated by multiplying the OI with the delta of an option and the contract multiplier.

What would this result in?

Narayan said that the immediate outcome of such a transition would be reduction in the number of instances of stocks unnecessarily being pushed into ban periods. He said, "Today, if there is excessive trading in Out-of-The Money (OTM) strike options, that can show up as a large amount of Notional OI in options, approach MWPL, and therefore create a ban period in a stock." This induced ban can then be used to manipulate stock prices, as explained earlier.

The proposed delta-weighted OI will also give a better representation of the risk an investor is exposed to. This is particularly important when it comes to the risk exposure of institutional investors.

To use Narayan’s example: If one buys ATM calls and sells completely OTM for the same notional value contract, that would show up as zero utilisation of risk. But this is contrary to reality.

The risk profile of an ATM call buyer is very different from that of an OTM call seller, and therefore one should not cancel out the other.

The ATM call is highly sensitive to an underlying asset’s price movements while an OTM call is not very sensitive to a move in the underlying asset's price. With the current system of notional OI, the investor will be seen as taking zero risk when the investor is actually taking a risk.

Are there other benefits?

With Delta OI, the MWPL may be raised, which can improve liquidity for the underlying asset and lead to more efficient price discovery.

Will the new system be perfect then?

No, the regulator is well aware that delta alone is not necessarily a sufficient metric and that, in options, as market prices move, the delta can change very rapidly". Narayan said, "Conscious of this, we will try and find a balance between simplicity and measuring risk appropriately."