SEBI’s consultation paper on index derivatives framework, released on July 30, proposes various measures to reduce speculation, particularly in index derivatives. The market regulator made a study and put out its observations based on which a seven-point plan has been formulated. Note that these are in the proposal stage and are yet to be implemented. Below are the details.

Rationalisation of strike prices for options

Currently, at the time of introduction of option contracts, 35 in-the-money (ITM) and 35 out-of-money (OTM) strikes are introduced in Nifty 50. For Bank Nifty, 45 strikes each of ITM and OTM strikes are introduced. This roughly covers 7 to 8 per cent of index movement from the prevailing price.

This led to scattering of liquidity across multiple strikes. Traders were more interested in far OTM strikes due to their small premium, which most of the time expired worthless, resulting in a loss for option buyers.

So, SEBI has proposed to introduce strikes that are within 4 per cent on both sides from the prevailing price and increase the strikes as the index moves away from the going price. Also, not more than 50 strikes (as against the current 70 and 90 in Nifty 50 and Bank Nifty respectively) are to be introduced at the time of launch of the contract.

Upfront collection of option premium

Upfront margin, money marked against a trade, is stipulated for futures and short positions in options (option writing/selling). Usually, option buyers pay the full premium while going long on a contract. But with respect to margins, as of now, there is no explicit stipulation in upfront collection of premium. Currently, clearing corporations block collateral for option buy trades at clearing member-level. As per the new proposal, the collection of option premiums will be checked at individual trader-level to ensure proper collection of margins.

Removal of calendar spread benefit on expiry day

Calendar spread is an option strategy where one buys and sells the same type of option (calls or puts) of the same underlying with same strike price but different expiry dates. This strategy is done to reduce the risk and benefit from the time decay of options.

For example, you can construct a calendar spread using Nifty options — buy one lot of 24000-call expiring August 22 and simultaneously sell one lot of 24000-call expiring August 29.

If you had sold 24000-call alone, the margin obligation would be around ₹70,000 for a notional exposure of ₹6,02,500. But if you execute the above calendar spread, the combined margin obligation will be approximately ₹21,000 only. This is because, in a calendar spread, the risk of the short position is hedged by an equivalent long position albeit different expiry. But note that, after the expiry of August 22 expiry call, the margin obligation of August 29 expiry call can go back up to ₹70,000.

However, the SEBI study notes that there is an element of liquidity risk. For example, even though both options in calendar spread are of the same strike, the change in premium of these options for a change in an underlying can vary significantly. This can be because of lack of participation in away/month options or excessive action in near week/month options, leading to very high volatility in the premium. This can lead to considerable losses in calendar spread.

Hence, it is now proposed that margin benefit for calendar spread would not be provided if any of the options involved in the strategy is expiring on the same day.

Intraday monitoring of position limits

Single stock futures and options have trade restrictions based on market wide position limit (MWPL), which is 20 per cent of the number of shares under free float. So, when aggregate Open Interest (OI) in futures and options across exchanges exceeds 95 per cent of MWPL at the end of a trading day, that particular stock will be put under F&O ban. So, participants will be able to take only offsetting trades of liquidating the existing positions so that the OI reduces. Normal trading will resume when the aggregate OI drops to 80 per cent of MWPL. However, at present, index derivatives have no such restrictions.

SEBI recommends monitoring position limits for index derivatives also and rather than at the end of the day, it is proposed to be monitored on an intraday basis so that the limit is not breached during the course of a trading session. Nevertheless, the position limit for index derivatives has not been defined.

Minimum contract size

The value of derivative contracts is ₹5-10 lakh currently. This limit was set in 2015. Since then, the benchmark indices have gone up by nearly three times, but the derivative contract value has not been modified. So, the market regulator now suggests an increase in contract value in two phases spaced in six months.

In the first phase, the minimum value of derivative contracts at the time of introduction is to be increased to ₹15-20 lakh. In the second phase, which is after six months, the contract value is to be increased to ₹20-30 lakh. If this measure is implemented, the margin requirement will go up 3-6 times of the prevailing value on per contract level.

Rationalisation of weekly index products

Weekly options are the main source of the increase in explosion of turnover. As mentioned earlier, a large proportion of new entrants to market trade in weekly options. Having expiry on all five days of the week has only made things worse.

The level of hyperactivity can be seen in this — on an average, a retail investor holds an open position only for about 30 minutes. And the report notes that in many cases, the expiry day trading in options constitutes as high as 80-90 per cent of the total notional turnover of weekly index options in expiry week. SEBI believes this has implications on market stability.

So, it is being proposed that weekly options contracts be provided only on a single benchmark index of an exchange. Therefore, if this measure is implemented, NSE can only have weekly expiries on either Nifty 50 or Bank Nifty and BSE can only provide weekly contracts on either Sensex or Bankex.

Increase in margin near contract expiry

Since most of the activity is happening around expiry, volatility tends to be higher. SEBI feels that for the higher volatility, more margins need to be brought in, particularly for index options, to account for higher risk.

Normally, full premium is paid for long positions whereas for a short position in options, around 12 per cent of the value of the underlying is collected as margin from option sellers. That is, 10 per cent SPAN margin plus 2 per cent Extreme Loss Margin (ELM).

For illustration, consider the above-mentioned Nifty 24000-call expiring on August 29. The value of the index is currently around ₹6,02,500 (price of underlying index of 24,100 multiplied by the derivatives lot size of 25). So, to create a short position, the margin required will be approximately ₹72,300 (12 per cent of ₹6,02,500).

To factor in the higher volatility, and thereby higher risk, SEBI proposes to increase ELM by 3 per cent at the start of the day before expiry. ELM will further be increased by 5 per cent on the expiry day.

So, margin for short option will go up to 15 per cent and 20 per cent on the day before expiry and on expiry day respectively. So, accordingly, the margin requirement will be ₹90,375 and ₹1,20,500. This will significantly reduce the return-on-investment for option writers, especially for expiry day traders.

Whether SEBI implements all the above measures or not is something to be second-guessed. If done, traders will have to shell out more margins in a less flexible environment, effectively making index option trading, especially on expiry day, difficult.

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