Update: NSE has reintroduced Do Not Exercise Facility (DNE) in stock options from April 28, 2022.
Physical delivery of stock options can potentially lead to systemic risk in the capital markets and pose a risk to traders. But before I explain these risks, let me first set the context with an outline of the regulatory changes over the last few years that have led to this.
Stock futures and options in India were cash settled until October 2019, and since then, compulsory physical delivery on expiry was introduced. So if you hold a stock future or a stock option contract that expires in the money on expiry day, you are required to give or take delivery of the entire contract value worth of the underlying stock. You can read this post for more details.
While physical delivery started in October 2019, the physical delivery risk I alluded to started only from October 2021 when exchanges published a circular discontinuing the DNE (Do not exercise facility) for CTM strikes (option strikes that are expiring close to market).
DNE facility was introduced in Aug 2017 after multiple representations from the industry about the STT issue. For all stock options that expired in the money, STT used to be charged at 0.125% of the entire contract value (as physical delivery trade) and not at 0.017% of premium value if sold on the exchange. At that rate, STT used to be much higher than the premium value for option strikes that expired close to the market value (CTM). Traders with just a few thousand rupees of premium in a CTM contract losing lakhs of rupees in STT was a frequent occurrence. You can check this post to know more. DNE facility allowed brokers to not exercise option strikes on behalf of customers where the STT value was greater than the premium value of the expiring in the money option contract.
DNE was removed in October 2021 because the STT risk didn’t exist anymore. Back in Aug 2019, STT on exercised option was reduced from 0.125% of the contract value to 0.125% of intrinsic or premium value. So STT paid was always a small portion of the premium, even on exercise.
But with the removal of the DNE facility, the risk that existed in terms of higher STT now has shifted to the risk of customers ending up having to take or give delivery without sufficient funds or stocks in the account. When the DNE facility was introduced, stock options were cash-settled, so while it was fair to remove it considering STT wasn’t an issue anymore, but maybe the risk of physical delivery with the removal of the DNE facility wasn’t taken into consideration.
The physical delivery risk
Like I mentioned earlier, if you hold stock futures or any in the money stock option at the close of expiry, you are assigned to give or take delivery of the entire contract value worth of stocks. Since the risk goes up with respect to the client not having enough cash to take delivery or stock to give delivery, the margins required to hold a future or short option position goes up as we get closer to expiry. Margins required are a minimum of 40% of the contract value for futures on the last day of expiry. For in the money long or buy option positions, a delivery margin is assigned from 4 days before expiry. The margins for in the money long options go up from 10% to 50% of contract value—50% on the last two days of expiry. If the customer doesn’t have sufficient funds or stocks to give or take delivery, the broker squares off the contract. If the customer shows an intent to hold after the higher margin is blocked, it shows an intent to give or take delivery.
The risk though comes from out of the money options that suddenly turn in the money on the last day of expiry. No additional margins are blocked for OTM options in the expiry week, and when it suddenly turns in the money, a customer with small amounts of premium and no margin can get assigned to give or take large delivery positions, causing significant risk to the trader and the brokerage firm.
This happened on Dec expiry, Thursday 30th Dec 2021. Shares of Hindalco closed at Rs 449.65 at expiry. This meant that the Hindalco 450 PE expired just in the money by 35 paise. This meant that everyone who had bought this 450 PE and held it at the expiry was required to deliver Hindalco stock—1075 shares for every 1 lot of Hindalco held.
This is what happened to Hindalco shares on 30th Dec:
The stock was above Rs 450 for most of the expiry day and even a few days prior to it. Since it was out of money, no additional physical margins would have been charged, and everyone holding this strike would have assumed that it would expire out of the money. In all likelihood, everyone who held this put option would have written off the trade as a loss and assumed that the maximum loss would be limited to the premium paid.
So at 3 pm, when the Hindalco stock price went below 450, this was how the marketdepth looked like. Those who realized that this option would expire in the money trying to exit, but with no buyers to be able to do so even at Rs 0.05 when the intrinsic value of the strike was Rs 0.35.
Everyone holding long puts would have been forced assigned to deliver Hindalco shares. 1 lot of Hindalco = 1075 shares = ~Rs 5lks contract value. Customers who had bought put options with a few thousand rupees were potentially required to deliver tens of lakhs of Hindalco stock. Failing to deliver would have meant short delivery. The consequences of short delivery are losses in terms of auction penalty, apart from the market risk of Hindalco stock price going up from the close of expiry to the auction date. Hindalco stock was up 5% already on Friday, and the auction happens on T+3 days or on Tuesday, and assuming the stock price doesn’t go up further, that is still a whopping loss of Rs 25 (5% of Hindalco) for Rs 0.35 worth of premium at market close.
If this wasn’t puts but calls, there wouldn’t be a short delivery risk, but there would still be a market risk that the customer would be exposed to from the close of expiry to when the customer can sell the stock. But in case of buy delivery (Buy futures, buy calls, short puts), the stock can be sold the next day itself and hence there is no marked to market risk of 3 days. The risk is exponentially more in the case of F&O positions that can lead to short delivery (Short futures, sell calls, buy puts).
The risk exists with futures, short options, and buy ITM options as well. But since there are sufficient margins that also go up closer to expiry, a customer who provides additional margin is willingly holding the position, or else the position is squared off. Because there are no additional physical delivery margins for OTM options and because most option buyers think that when they buy options the maximum they can lose is equal to the premium paid and take no action, the risks go up for the entire ecosystem. Here is a comment from Tradingqna.
Apart from the risk to the trader, this can be a systemic issue because if a customer account goes into debit, the liability falls on the broker. A large individual trader or group of customers of a broker could potentially go into a large enough debit to bankrupt the brokerage firm and, in turn, put the risk on other customers as well. Stocks can move drastically on expiry day, and out of the money, option contracts can suddenly move just in the money with no liquidity to exit, making it impossible for brokerage risk management teams to do anything. All option contracts are settled based on the last 30 min average price of the underlying stock and not the last traded price, making this even trickier without knowing if a CTM option strike will actually close in the money or not until post the market closing. And like I explained earlier, the risk is not just in terms of the auction and short delivery, but also marked to market risk for 3 days.
By the way, if you look at the market depth above of Hindalco 450 puts at around market close, what if someone with a malafide intent of hurting a brokerage firm bought thousands of lots of puts paying just Rs 100 per lot from a customer account? The potential damage due to margins for firstly being assigned to deliver tens of crores of Hindalco stock and then the losses due to auction penalty and marked to market would be enough to bring a small to mid-sized brokerage firm down. At Zerodha and a few other online brokerage firms, we have blocked fresh buy stock option positions two days before expiry to protect from this risk, but the risk management policy is different across brokers. But not allowing trading only increases the illiquidity problem in these contracts.
Forcing traders to give or take large delivery positions can potentially be misused by large traders or operators wanting to manipulate the price movement of stocks.
- Reinstate the Do not exercise (DNE) facility. While some have claimed that it hurts option writers, it doesn’t. If anything, option writers tend to gain from the additional premium when a just in the money or CTM option contract expires worthless. It is maybe a good idea to extend DNE beyond the CTM contracts as well. As long as the buyer of the option thinks that the cost of taking or giving delivery is higher than the premium, it is good to give the DNE facility to not exercise and not force the option buyer to take large risks and losses. There is international precedence for this as well, check this link from the OCC (Options clearing corporation in the US) for both their stock (American) and index (European) options – The option holder can always submit instructions to their broker regarding whether to exercise or not to exercise.
- The broker associations have requested to have a post expiry trading session where all F&O stocks are allowed to be traded within a 1% window. This session can be used to either purchase or sell stocks for all those for whom there is stock delivery assigned due to an in the money option or futures expired contract.