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."

life in financial markets: good future for options

Equity derivatives has its utility for long-term/short-term investors, day/week traders/speculators & arbitrageurs.

Derivatives involves futures and options. Which among the two are better -- futures or options? If you are 100% confident of a price movement in a particular, either up or down, direction then futures are better. If you are somewhat confident but fear a potential opposite movement then buying options is better. Buying and selling options are different from buying and selling futures. The latter is similar to buying and selling shares from the cash market.

Options, when bought, give the buyer a right but not an obligation, to buy (as in a Call option) or sell (as in a Put option) the underlying. The buyer pays a premium, determined and traded in the exchange, which he never gets back, no matter what. When sold, options oblige the seller to sell (as in a Call option) or buy (as in a Put option) if the buyer exercises the option. The seller receives the premium that is her's for keeps.

So, buying options entail keeping all profits and limiting the maximum loss to the amount of premium paid in buying the option. Selling options entail taking unlimited risk of loss and getting to keep a maximum profit of the amount of premium received in selling the option.

So, why will anyone sell options? Generally, sellers of options do not sell options only to take a view on the movement of the underlying. Their option sale is a part of a strategy (strangle, calender spread, and many more) that involves another/multiple trade/s in cash market, futures or other tenure/strike price options contract.

There is perhaps only one condition under which you could have just an option sale and nothing else. Say, you are looking at Nifty 29Oct09 Call Options prices right now (11 am) and you see if you sell it you will get around Rs 175. The underlying Nifty is quoting at 4907 in the spot market right now. On selling this call, you will lose money if Nifty stays above 4900 on any date before 29 October when you want to square off or on 29 October, expiry date, when the trade is automatically squared off. You will gain if Nifty stays below 4900. Now, you could have sold Nifty 29Oct09 futures at 4907 instead of selling a Call option. But if Nifty is at, say, 4850, on expiry or on any day when you want to square off. You profit only Rs 50 whereas you have already profited Rs 175 by selling the Call option. The flip side is that if Nifty falls to, say, 4600, then a sold futures trade would profit Rs 300 whereas your maximum profit in the Call option sale is Rs 175.

Also, if Nifty goes up to, say, 5000 then the futures trade would have given you a net loss of Rs 100, whereas in your Call option sale trade you have lost Rs 100 in the option trade but you have already received Rs 175 as premium when you sold the Call option. So, while your profits are limited to the premium you received in your Call options sale trade your losses, though unlimited, are also less by the premium amount. In Futures sale trade you gain unlimited but the quantum of your unlimited potential loss is more as compared to the loss in Call options sale.

Anyway, I spotted a trend in Indian equity derivatives market where trading turnover in in options trades are rising to match that in futures trades. I wrote about it last month in the magazine I work for currently.

Here it is:

Refuge option

For the first time ever, options trading in equity derivatives is playing a prominent role compared to futures.The risk appetite of investors in domestic and global equity markets might have gone up with regard to making investments in the cash market from a short-term, or long-term, perspective. But the unprecedented intra-day volatility in the domestic equity market is causing those investors and traders who play the equity derivatives market on an intra-day, or inter-day weekly, basis to tweak their investing style so far.

They are increasingly dabbling in options trades on the National Stock Exchange (NSE), particularly options on the S&P CNX Nifty. From 1 July to 18 August, the options' traded value (notional) has crossed that of the futures on NSE's derivatives trading segment a higher number of times, 9 out of 35 trading sessions, than ever before.

Since their advent, the Indian equity derivatives market's trading trends has deviated from those in overseas developed derivatives markets where options trading dominates. For many years, the futures on Nifty and stocks traded much more than options on Nifty and stocks. "This began changing, and one saw trading volume in options rise rapidly, after the markets crashed during 2008 and investors' risk appetite came down sharply," says Sandeep Nayak, senior vice-president and head of private client group at Kotak Securities, a NSE-cum-BSE broker.

Aggregated for financial year, 2008-09, options trades contributed to a healthy 35.9% of all equity derivatives trades on the NSE. The current financial year's aggregate figures so far, till 17 August, has seen options' contribution to total has become even healthier at 42.2%.

Day traders, ultra short-term investors and foreign institutional investors (FIIs) are driving the change from futures to options. "Earlier, a typical day trader client of ours would trade in 20 Nifty futures contracts in the derivatives segment, but now the same guy is trading in 15 Nifty options contracts and just 5 Nifty futures contracts," says Mrugank Sanghvi, a dealer in Jagvin Investments, a NSE broker.

(click on image below to see it enlarged & clear)

The FIIs who, unlike domestic institutional investors, are allowed to speculate freely in equity derivatives, are doing alike. In recent months, of the total trades in equity derivatives, FIIs' trades make up for between 10 and 20 per cent on an average.

As per FIIs' derivatives trading data, released by the Securities and Exchange Board of India, for the first time, FIIs' aggregate trades (sum of purchases and sales) in options in August, upto the 17th, were more than their trades in futures, amounting to 56% of their total derivatives trading value. In June and July, their options trades' proportion was 41% and 49% respectively.

More than 90% of options trades are taking place in index options, primarily in Nifty options, and the balance in stock options. In futures trades, the spoils are shared roughly equally by index futures and stock futures. "The high liquidity in Nifty options is a major attracting factor for traders," says Sanghvi. "This was earlier limited only to Nifty futures and futures in select stocks."

The shift in trader preferences from futures to options, according to Kotak's Nayak, is on account of convenient trading strategies in options and synthetic stop loss trades through a combination of options and futures. The high volatility in Nifty was resulting in top loss trades (stops) in naked Nifty futures positions get triggered too often. The stops do not get triggered when done through a synthetic stop using options.

"When it comes to FIIs, we are seeing some of them sell call or put options of various strike prices and buy or sell futures to make it a delta neutral position," says Nayak. Traders, including FIIs, with views are getting hit by new information much more often in the recent weeks' dynamically shifting undercurrents in the stock market. Options contracts, therefore, acts a refuge for such times.

Whether the new trend will sustain or not is not certain, given the propensity for most brokerage firms to give to their retail investor clients recommendations on derivatives strategies involving only stock and Nifty futures. "But the phenomenon of high options trading volume is here to stay," says Nayak. Investors will be glad if Nayak is right.

life in financial markets: equity derivatives open interest position on the NSE

I did an analysis from data taken from 3 October 2008 trading data file of National Stock Exchange's equity derivatives segment to see what was going on. Here is a summary (click on the image for a clear view):

* – as on 3 October; based on Open Interest outstanding multiplied by (a) settlement price for futures and (b) (settlement price+strike price) for options