Capital markets regulator SEBI has announced a slew of measures to strengthen equity index derivatives framework following its consultation paper on July 30, 2024. SEBI says these measures will ensure investor protection and market stability. Via its latest circular, the regulator has called for an upfront collection of "option premium" from options buyers, removal of calendar spread treatment on the expiry day, intraday monitoring of position limits, contract size for index derivatives, and rationalisation of weekly index derivatives products, and increase in tail risk coverage on the day of options expiry.
Options to be paid upfront
SEBI has now decided to mandate the collection of options premium upfront from option buyers by the trading member (TM) or clearing member (CM). This has been done, says SEBI, to avoid any undue intraday leverage to the end-client, and to discourage any practice of allowing any positions beyond the collateral at the end-client level. Options prices move in a non-linear way and carry very high implicit leverage. These are timed contracts with the possibility of fast-paced price appreciation or depreciation.
Explaining what this means, Deepak Shenoy, founder and CEO, CapitalMind says on X that option premiums have to be paid by options buyers. "Sounds obvious, but currently, intraday, the exchanges just block the broker's collateral for options bought, which therefore allows one person to effectively buy and sell intraday using another person's collateral." He says this must be for a few brokers that provided this facility to allow "mad" intraday options buy positions. "From Feb 2025, this won't happen - clients will have to pay up from their money for such purchases."
No calendar spread on expiry day
The regulator says the benefit of offsetting positions across different expiries ('calendar spread') will not be available on the day of expiry for contracts expiring on that day. Expiry day can see significant basis risk, where the value of a contract expiring on the day can move very differently from the value of similar contracts expiring in future. The relatively large volumes are witnessed on the expiry day vis-à-vis future expiry days, and it also represents an enhanced basis risk.
SEBI says it would also align "calendar spread treatment" with a cross-margin framework on correlated indices having different expiries, wherein such cross-margin benefit is fully revoked at the start of the first of the expiring correlated indices.
"This is not a bad idea, as there was a large amount of retail scalping happening on daily options expiries, especially selling straddles. There is systemic risk in case the offsetting calendar option doesn't move anywhere close to the expiring one (can happen in case of sudden spikes) - which makes sense on expiry day because max trading happens there," says Shenoy.
Intraday monitoring of position limits
The market regulator says that existing position limits for equity index derivatives will also be monitored intra-day by exchanges from now on. SEBI fears that amid the large volumes of trading on expiry day, there is a possibility of undetected intraday positions beyond permissible limits during the day. This change will address the risk of position creation beyond permissible limits.
"To therefore ensure that one broker doesn't breach the limits, SEBI says exchanges have to monitor the limits intraday (4 times a day). This means that if a broker hits limits, you can't do fresh trades and can only close existing ones until the broker level OI is less than the limits allowed," he adds.
Contract size for index derivatives
SEBI has decided that the derivative contract will have a value not less than ₹15 lakh at the time of its introduction in the market. Further, the lot size will be fixed in such a manner that the contract value of the derivative on the day of review is within ₹15 lakh to ₹20 lakh. All other stipulations for the contract size of index derivatives will remain unchanged.
The current stipulation is for such contracts to have a value between ₹5 lakh and ₹10 lakh, which was last set in 2015. Since then, broad market values and prices have increased by around three times. Given this, SEBI decided to increase the derivative contract value to ₹15 lakh. "This is good. Higher lot sizes are just a function of the GDP growing. In the US, the median contract size in the top 100 is about $17000, which is about 14 lakh rupees," says Shenoy.
One weekly expiry per exchange
To address excessive trading in index derivatives on expiry day, SEBI has rationalised index derivatives products offered by exchanges, which expire every week. "Henceforth, each exchange may provide derivatives contracts for only one of its benchmark index with weekly expiry," says SEBI, adding that it will be effective from November 20, 2024. From this date, weekly derivatives contracts will only be available on one benchmark index for each exchange. "While I don't think the volumes will reduce (people will just move to the weekly that they can instead) but it's better than having the madness daily. And with the other calspread removal, upfronting of options premium etc. the volumes should subside a little at the extreme retail end," says Shenoy.
Increase in tail risk coverage on options expiry
The tail risk coverage will now increase after the levy of an additional extreme loss margin (ELM) of 2% for short options contracts. ELM is levied to cover tail risk outside the scanning risk. This would be applicable for all open short options at the start of the day, as well as on short options contracts initiated during the day that are due for expiry on that day. "Higher expiry day margins: Short options will see 2% higher Extreme Loss Margins on expiry day. This will just ensure that the short-straddle kind of plays on expiry day become more expensive," says Shenoy.
