Sebi proposes converting ITM options into futures one day before expiry

Proposed framework on the lines of one followed in the commodity market

Market regulator Securities and Exchange Board of India (Sebi) on Thursday proposed a framework to convert ‘in the money’ single stock option contracts into futures a day before the expiry.

 

Currently, there is a mandatory requirement of physical settlement of stock derivatives. If an ‘out of the money’ (OTM) option suddenly turns ‘in the money’ (ITM) on the expiry day, the ITM option holder is obligated to bring in the cash or securities to honour the physical settlement.

 

Sebi has observed that this could pose potential risk to the settlement process if the position is large and such an option holder fails to honour the same.

 

“It is proposed that ITM (in the money) options instead of directly resulting into physical delivery obligation on expiry will initially devolve into stock futures on the day prior to expiry i.e., E-1 day. Thereafter, the resultant stock futures positions can be closed on the expiry day i.e., E day,” said Sebi.

 

In option trading, traders predetermine a strike price at which a ‘call’ or a ‘put’ option contract can be traded on the expiry day

 

While an ‘out of the money’ option refers to a situation where the current market price of an underlying scrip is less favourable than the strike price of the option-- meaning exercising the option is less profitable.

 

‘In the money’ call option refers to a profit opportunity for the option holder with the strike price lower than current stock price.

 

Under the proposed framework, only futures will be tradeable on the expiry day. However, open futures positions will continue to be settled by delivery on the expiry day.

 

This model is currently followed in the commodity markets.

 

Sebi said that the change is intended to address risks associated in case where significant obligation arises during physical settlement requirement in single stock derivatives and when an “out of the money” option unexpectedly becomes “in the money” due to sudden price movements on expiry day.

 

The market regulator added that the proposed framework may not necessitate any major change in the margining system.  

 

In August 2017, stock exchanges had introduced the “Do not exercise (DNE)” framework for cash settled stock options. DNE was to avoid traders having negative pay off as the securities transaction tax (STT) had to be paid on notional value of contracts. Later in 2019, STT was rationalised and levied on the intrinsic value of the option. In 2021, DNE was discontinued as concerns related to negative pay off were no longer relevant.