March 07, 2010

life in financial markets: delivery-based settlement in stock-futures&options

Yesterday (Saturday, 6 March), the Securities and Exchange Board of India, after its latest board meeting, had, as it does after most board meetings, a press conference to announce the decisions made in it.

One of the decisions made to allow the stock exchanges in the country to have delivery-based (or physical) settlement in futures and options contracts on individual stocks. Uptil now, Sebi's rules permitted the exchanges to have only cash-settled futures and options contracts.

I think a delivery-based settlement of stock futures-options is better than cash settlement. Sebi's leeway to stock exchanges on this matter should have come back many years back. Anyway, it is better later than never.

It is upto to the National Stock Exchange of India now to use this new-found freedom to either replace its existing cash-based settlement of stock futures-options with delivery-based settlement or have a mix of both based on pre-fixed parameters.

As long as 8 years ago, in April 2002, when I was with Outlook Money magazine I had written about the need to have delivery-based settlement.

Here is what I wrote then:

Sebi delays derivatives reforms

Dealing in futures and options on stocks turns hazardous as Sebi drags its feet on making options and futures on stocks settle by delivery instead of cash.

April/May 2002

Any trade in the stock market carries behind it an objective. It could be to invest for the long-term or to implement a very short-term view or to take advantage of arbitrage opportunities. Whatever objective you are trying to achieve through your trade in the market you surely do not want any systemic flaws to hit you adversely.

Today, however, if you are using the derivatives market you are faced with one such serious systemic flaw. The futures and options contracts on stocks are currently settled by cash instead of delivery giving rise to difficulties for those who are using these two derivative products for achieving their objectives.

In options on stocks settlement takes place when a in-the-money options contract is exercised—voluntarily before expiration (as allowed in American-style options which applies on National Stock Exchange and Bombay Stock Exchange) or automatically on expiration date. When the option buyer exercises his option through his broker the stock exchange assigns it randomly to a option seller in the same options contract. The option seller pays his broker in cash the difference between the strike price (at which he sold the options contract) and the exercise settlement price (closing price of the underlying stock on the day of exercise).

The other way to settle options is through delivery. On exercise, the call option seller will deliver shares and a put option seller pays money which is then passed on to the respective option buyers. Similarly, in stock futures contracts, today, the settlement which takes place on the expiration date is through paying or receiving the difference in cash instead of through an exchange of shares and money.

Mrugank Sanghvi, an investor, was recently affected adversely due to the cash method of settlement. On February 18, when Hindustan Lever was trading a little below Rs 240 in the cash market, he sold 1000 HLL March call option of strike price 240 at a premium of Rs 10 on the NSE. His view was that HLL would not rise beyond Rs 250 and so the option will not be exercised and he would stand to profit Rs 10 from the premium received.

Sanghvi already had HLL shares in his portfolio which he was willing to deliver in case HLL went above Rs 250 and his option was exercised by the buyer. But he knew he could do not do this since options are cash settled. Sanghvi, therefore, instead went for the equivalent of holding HLL shares. He bought 1000 HLL March futures which was trading at Rs 240 at that time. He thought that if his options got exercised beyond Rs 250 then the loss he would incur on account of that would be offset by an equivalent amount of profit he would earn from squaring off his futures position. His net profit would remain as Rs 10—the amount received as premium on selling the option.

Option-buyers can exercise their option anytime between 9.55 am and 3.50 pm on the NSE and the exchange assigns it randomly to option-sellers after 3.50 pm. The settlement price is the closing price of the underlying and the NSE calculates the closing prices of all its stocks as the weighted average of the last 30 minutes of trading of the day.

On March 1, HLL closed at Rs 262.83 and some buyers of call option exercised their option contracts. On the morning of the next trading day—March 4—Sanghvi found that he was assigned with one such exercise. His loss on his options contract was Rs 22.83 (settlement price Rs 262.83 minus strike price Rs 240) which he was required to pay in cash. But by now spot HLL price and HLL March futures price were down. Sanghvi sold his futures at Rs 250 thereby getting a gain of Rs 10. As a result, he incurred a net loss of Rs 2.83 (loss on options Rs 22.83 minus premium received Rs 10 minus profit on futures Rs 10).

This upset all his calculations since his futures was supposed to fetch a profit equivalent to the loss on his options, and his net profit was to be Rs 10. Says Sanghvi: "Had the settlement been in delivery I would have been required to deliver shares on the call option being assigned to me. In that case, I would not have bought the futures at all since I had HLL shares in my portfolio which I would have used for giving the delivery." This way Sanghvi would have retained the amount of Rs 10 he received as premium and he would have replenished his portfolio by buying HLL shares any time again in the future at a price favorable to him.

Traders in stock futures contracts are exposed to the same risk. You may buy spot and sell futures in a stock with the intention of pocketing the difference between a higher futures price and a lower spot price. But on expiration date which your futures would be settled in cash difference and you would be required to sell the shares bought separately instead of just delivering it against your futures contract settlement. On expiry date, you will run the risk of selling the shares in the spot market at a price different from the futures settlement price since the latter is the closing price of the stock in the cash/spot market which in turn is based on a weighted average of trades in the last 30 minutes of trading hours, and the former is the price you get when you sell towards the close of trading hours. Plus, you would incur additional transaction costs.

When options on stocks was introduced in July last year on the NSE and BSE the Securities and Exchange Board of India had specified that the contracts would be cash settled for an initial period of six months. Same was the case when stock futures commenced in November last year.

Nine months are now over since options on stocks commenced. But Sebi has not asked the stock exchanges to the settle the contracts by delivery. When asked about the delay, A.Satyanarayana, Sebi spokesperson says: "I do not know the reasons for the delay but the matter is being considered by the Sebi board."

The stock exchanges, in the meanwhile, are ready with their systems awaiting the green signal from Sebi. Says Sanjiv Mehta, CEO of BSE's derivatives segment: “Based on the existing framework the BSE is ready with its systems to settle stock options by delivery”. But the existing framework will undergo fine-tuning by Sebi. Says Raghavan Putran, director, business operations, at NSE: "Our clearing software has the capability to incorporate any new specifications received from Sebi and then it will take only three weeks for us to test it thoroughly before going live with it."

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