Short Call: No DNE rule by NSE changes definition of options for buyers

The NSE decision to scrap DNE will not make a big difference, say a section of brokers. (Representative Image)

“Many years ago, an older partner taught me to distinguish between outcomes that are unlikely and outcomes that are catastrophic. The latter are to be avoided even if the odds on them are tiny.” ~Peter Bernstein

The market is going nowhere. The global banking crisis appears to have been contained for the time being, but that is still not a compelling enough reason for investors to start loading up on shares in a big way. With the fourth quarter earnings season set to start in less than three weeks, the focus will once again shift to earnings growth. The good part is that expectations are low this time around. The question is: whether the low expectations are already reflecting in the stock prices?

Option or mandatory?

The big talking point yesterday was the National Stock Exchange’s decision to scrap the ‘Do Not Exercise’ (DNE) facility in the futures and options segment. The new rule means that all open In-The-Money (ITM) single stock options at expiry will have to be settled by giving delivery or taking delivery of shares. This is applicable even to the buyer of options, irrespective of how miniscule the profit may be. Many traders choose DNE because settling in shares even for hugely profitable ITM options is a cumbersome process. And where the profits are miniscule, option buyers prefer to forgo the amount paid as premium since settling in shares would mean shelling out broking and other statutory charges, which would far exceed any profit that they stood to make on the trade.

Rajesh Baheti of Crossseas Capital has a point when he says that the NSE has turned the concept of an option on its head by turning choice into an obligation. If the holder of an option has to compulsorily buy or give delivery of shares, how is it even an option contract in the first place. The circular scrapping the Do Not Exercise facility had been issued by NSE in January itself, but the market awoke to it only now.

It is not clear what exactly the NSE or SEBI hopes to achieve by this rule. A section of the market feels this is being done to curb retail investor activity in single stock options, which are prone to manipulation unlike the more liquid index options. With the DNE facility no longer available, retail traders cannot afford to wait till the last minute to square off their open positions in single stock options. That is because if the options become ITM by a narrow margin, it would considerably add to the costs of the trader. In a way, this could make single stock options a risky proposition and at the same time unattractive because traders will have to at times square off in a hurry, or have their positions squared off by the broker at whatever price available.

Some others say the move is being done to make retail investors more responsible or ensure that only the knowledgeable traders among retail dabble in options.

But if that was indeed the aim, targeting single stock options may not really solve the issue. Because most of the retail traders prefer to punt on Nifty and Bank Nifty. Volumes in single stock options are less than 10 percent of the overall F&O volumes.

Whatever the case, volumes in near-the-money contracts could get hit in short because of the rules. That is because unless the trader can show that he has enough money in his account, the broker will not allow him to trade in near-the-money options.

The NSE decision to scrap DNE will not make a big difference, say a section of brokers.

“For a long time, the DNE facility was not available though physical settlement of open options contracts was applicable. Back then, the brokers’ back office would ensure that the open positions were squared off either voluntarily or compulsorily. With the DNE facility scrapped, we are just going back to the old system. Brokers and traders need to be watchful once again, that’s it,” a market participant told Short Call.