Do Not Exercise

What is the charm behind option trading? The key advantage that an option trader has is the ability to take part in similar movements in the underlying stock, without investing as much as required if it were the actual stock. As long as your intention is not to take the physical delivery of the stock. By definition, a stock option is a contract which gives its holder the right to buy (or sell) the underlying stock at a particular price and date. Here, the operative word is “right”, suggesting that the trader is not obliged to buy (or sell), and it is up to the trader to exercise this right or choice. However, a few regulatory changes, one, came close to taking away this choice. Or did take away in fact, for a while, before normalcy was restored.

What led to the Hindalco incident?
On December expiry, not long before close, liquidity thinned, making it difficult for 450 strike put buyers to square off their positions. What lent urgency to this situation was that Hindalco stock which was trading steady and above 450 for the major part of the day, started slipping below 450 after 2pm, resulting in a close of 449.65, or in option parlance, 35 paise in the money (ITM). In other words, an hour’s trade drastically changed the setting for the put option buyers whose positions looked almost certain to end worthless resulting in just the loss of the premium paid already. However, since all stock options that expire in the money go for compulsory physical delivery, the Hindalco put option buyers in this case, were now compelled to deliver the underlying stocks (1075 stocks per lot). As the auction price of Hindalco was 480, every ITM trader had to shell out 5,16,000 rupees (1075, the lot size x 480 rupees) to procure the required physical shares (1075 shares, being the lot size of one option @ the price of ~450 rupees, amounting to 4,83,750 rupees) before delivering them to the put option seller @ 450, thus incurring a loss of 32,250 per lot. This is besides the penalty, interest charges, etc. All this pain, for a stock option that just 35 paise in the money, and which had an investment of just 2 rupees premium per option with a lot size of 1075, amounting to just 2,150 rupees investment per lot, could have been avoided, if investors were not compelled to exercise the option. Unfortunately, only a few months back in October 2021, the Do Not Exercise (DNE) facility was removed by SEBI.

The remedy must cure the malady
Though DNE was reintroduced, effective 28 April 2022, plugging such a hole, it leaves more questions unanswered. In the Hindalco incident, the absence of put writers towards expiry looking convenient, one wonders if hapless and innocent traders should have been made to bear the damages, and if the losses borne thereof might have been compensated by investor protection fund. More importantly, the October’s removal of DNE facility in a compulsory delivery environment, had changed the very definition of option, replacing the right to choose, with “compulsory”. How did one miss that?

Leave a Reply

Your email address will not be published. Required fields are marked *

You May Also Like