Out of option, and stock on expiry day, ‘new’ traders post big losses

This risk for traders stems from a situation where they are unable to square off their bets before the monthly contracts lapse – the last Thursday of every month. Holding seemingly profitable stock derivative positions till their expiry leads to compulsory physical settlement – bringing or giving shares worth the entire derivative contract value – an outcome that has inadvertently caught market participants on the wrong foot of late, resulting in steep losses.

An option is a contract to exchange an underlying asset like shares on its expiration at a pre-decided date. Until September 2019, India’s futures and options markets were cash-settled, which meant cash was paid instead of settling a trade with stocks. Now, they are settled with shares if held till expiration.

Agencies

Brokers said that in the past three derivative expiries, several traders who held stock options till the end ran into trouble because of their inability to deliver shares to meet the settlement obligations. This is because they did not have the shares in their demat accounts or lacked enough money to honour the commitment. The value of shares to meet the physical settlement has been multiple times the size of their options trade or even the net worth. The plot may play out this time too.

“Such losses can happen to anyone trading in stock options and holding them on the expiry day,” said Nithin Kamath, CEO at discount brokerage Zerodha. “The problem is some of these liabilities arising out of this are way beyond the reach of most retail traders which results in systemic risks.”

The risks around physical settlement surfaced following the discontinuation of the ‘Do Not Exercise’ or DNE facility for options expiring close to the stock price in October 2021. The DNE facility allowed brokers to stop exercising option contracts on behalf of clients.

While the arrangement was introduced to iron out an unrelated anomaly linked to the Securities Transaction Tax (STT), it also helped cut delivery-related risks in physical settlement for clients without enough shares or funds in their accounts. In the absence of DNE, traders who allow their contracts to expire are exposed to these risks.

The issue first came to light during the expiry of derivative contracts last December when a clutch of traders, who bought Hindalco put options, found themselves in a difficult situation.

They were unable to square off Hindalco puts just before the expiration of the contracts in the absence of buyers. The value of the exercised option of one retail client trading through a large bank-owned brokerage was over ₹42 lakh. Brokers said some traders faced similar problems in HDFC contracts in February.

“Some may not be able to square off due to lack of liquidity, while there have been cases where the weighted average price can result in an OTM (Out of the Money) contract at market closing becoming ITM (In the Money) post-closing which makes it mandatory to give delivery,” said Kamath.

A stock’s closing price on the NSE is the weighted average price of the last 30 minutes of trading.

Brokers said many retail traders are not even aware that holding contracts till expiry leads to physical delivery risks. If the client is unable to pay up, the liability falls on the broker. “Forget physical settlement; many traders have little clue of how options work,” said B Gopkumar, CEO at Axis Securities. “After the tighter margin norms, retail traders shifted from futures to options thinking that they were safe. A lot of the excesses are coming out in various ways.”

Kamath said a ‘simple way’ to cut physical delivery-related risks is to reintroduce the DNE facility.