SEBI proposes new way to measure risk in equity derivatives, says "will not materially impact" small investors

2. Mitigate the possibility and risk of circumvention of intended position limits for index derivatives (including via short positions).

The paper also added that these changes will not materially impact small investors  beyond reducing the
frequency of stocks entering ban period, thereby simplifying their trading experience.

Why the change?

A regulatory expert explained: "The proposed Future equivalent OI is additive across futures and options and gives a snapshot of the total risk being run at a point in time.

"With this better measurement, the chances of stocks being pushed unnecessarily into ban periods is expected to reduce by 90%, thus significantly enhancing trading convenience for a normal F&O trader."

There is also a risk-management measure for the index-derivatives segment. As he said, "with this better measurement, the chances of entities running very large positions especially in index options while notionally showing low open interest would be dramatically reduced.

"Finally, this better measurement of risk along with suggested minimum conditions for construction of F&O indices should reduce the actual and perceived risk of any manipulation across cash and derivatives markets, and of excessive volatility"

Apples vs Oranges

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 SEBI's Whole-time Member Ananth Narayan pointed out in a speech in January, adding OI across futures and options (to capture the total OI) is like adding apples to 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.

Single-stock vs Index derivatives

In single-stock derivatives, this wrong measurement can lead to the unnecessary triggering of market-wide position limit (MWPL) of the stock, leading to a ban in its trading except for closing existing positions, a situation which can be abused by operators to manipulate the stock price.

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.

With the current method of using notional OI, the ban can be induced by buying a large amount of cheap out-of-the-money (OTM) options.

While in single-stock derivatives, the current method may exaggerate risk, in index derivatives, the current method may hide risk.

As the paper states, "Currently, for index options, the monitoring mechanism adds long and short notional positions to arrive at a net figure. This allows an entity to hold large long and large short notional positions that effectively net out to zero in notional terms, despite carrying significant net Delta risk.

"As an example, long at-the-money call options and short out-of-the-money call options would not show net notional utilization, while implying a large net (long) delta risk."