SEBI Considers Reducing Number Of Strikes To Prevent Misuse Of Options

The Securities and Exchange Board of India has sought views from its secondary market advisory committee that met on Monday, said an official aware of the development. The person didn’t want to be identified as he isn’t authorised to speak to the media about regulatory issues.

That comes after BloombergQuint reported that the futures and options market saw a build-up in open interest—or the number of outstanding contracts—of June 2019 Nifty 50 call options for the 5,000 strike. It’s an unusual trade because the benchmark is unlikely to fall by more than half in five months.

These were call contracts where the strike price is significantly below the market price of the underlying asset. Called deep in the money calls, the buyer stands to gain even if an asset falls, remains unchanged or rises. The only way the investor could lose money is if the asset crashes below the strike—which is unlikely in most such trades.

In deep-in-the-money put options, the strike price is significantly above than the current market price. A call gives a holder the option, but not an obligation, to buy an asset at a pre-decided price, while a put gives an option to sell.

SEBI is aware that deep-in-the-money strikes, like in the Nifty 50 contracts, are used for negotiated trades to either transfer profit and loss or even lend money, the official quoted earlier said. The investor tends to get a big payout, he said.

The secondary market advisory committee comprises officials from SEBI, stock exchanges, market intermediaries, brokers and experts.

A stock exchange, according to trading regulations, needs to at least maintain a minimum of five strikes out of the money, one at the money and five in the money. The upper limit is 10. The exchange is also required to provide a strike to cover the price band of 20 percent above and below the current market price.

Options contracts are for the next three months. In addition, the stock exchanges also have up to three-year contracts that allow investors to hedge their portfolios.

It’s tough to reduce strike prices if there are outstanding contracts, according to derivative dealers BloombergQuint spoke with. They didn’t want to be identified as the regulator is still deliberating the matter. Moreover, they said, an investor can’t be asked to settle a trade before a certain date. Such a move would expose participants to risks as the options may have been part of their portfolio, they said.

The regulator suggested that exchanges look to extinguish deep in and out of the money strikes which don’t have open interest.

The committee is yet to take a decision. SEBI is yet to firm up its view on the issue. BloombergQuint has emailed queries to SEBI and the story will be updated once the regulator responds.

Traders suggested the exchange can look to limit build-up in open interest in deep strikes and release them automatically when the strike approaches a range, the official quoted earlier said. Or these can be linked to the overall market-wide positions of the security.

The ideal solution is to maintain surveillance and report manipulative practices to income tax authorities, the official said.