Reintroduction of DNE or a better option for Options Traders?

Market regulator Securities and Exchange Board of India (SEBI) and exchanges are discussing a proposal for bringing back a ‘Do Not Exercise’ (DNE) facility that helps traders avoid losses. Introduced in August 2017, the DNE facility enables traders to give instructions to the brokers that they do not wish to exercise their right to give or receive deliveries with. Hence, the DNE mechanism prevents the risk of physical settlement of trades in case ‘Out of the Money’ (OTM) options become ‘In the Money’ (ITM) at the very last moment on the expiry day.

As per sources, brokers have made a re-presentation to SEBI citing market-wide concerns. 

Currently, brokers charge delivery margin for ITM options. However, brokers do not charge delivery margins in ‘Close to the Money’ (CTM) and OTM strikes. Brokers and clearing members see it as a major concern and perceive it to have a huge market impact if the underlying security price moves even slightly during the last half an hour on the expiry day. There have been cases when on the expiry day, the close price of the security shifted and OTM calls became ITM, and as DNE was not an available option, buyers were forced to accept the delivery.

The Brokers Industry Standards Forum has suggested various options to deal with the issue. One of them is to reintroduce DNE as a simple solution. This option is proposed by options buyers, which is opposed by option writers.

The second option proposed suggests allowing a post-closing session with open price discovery. Currently, the demand-supply equation doesn’t match because the exit is at a fixed volume weighted average price of the last 30 minutes. At that price, there is no incentive for short sellers to step in. If there is a closing session, the price will not be limited, and demand and supply can allow the value to change. But this option has its issues. If the buyers force up the prices near close, there may not be enough supply of stocks to meet the demand created by last-minute change of OTM to ITM.

The third option suggested is allowing for the exercise of options at a time before 3:30 pm. This model is similar to currency options. In this model, the options will turn into a cash position at a specified time during the day, before closing at 3:30 pm. This model will have the biggest challenge of determining the closing price and calculating the real-time margin. Also, this may lead to speculation into closing. People may create a short squeeze and then sell it to options buyers saddled with stock.   

The fourth proposal suggests that the exercising of options into stock futures a day before expiry, Wednesday. The belief is that it’s difficult to manipulate closing price as compared to intraday prices. In this model, Wednesday’s closing price of the underlying will be used to convert ITM options into futures and then future positions can be closed on Thursday. This model is used in gold and crude contracts. But it contradicts the fundamental issue, which is that the option needs to be right which the option buyer may or may not exercise. In this option, the settlement will become ‘T+2’ for options contracts.

There is a fifth model also, which suggests the expiry of all contracts one day before expiry and then allowing DNE for all ITM options. After that, the resulting positions will be allowed to be settled by delivery one day after expiry. In this model, on Wednesday, all ITM stock options will convert into futures at the end of Wednesday after allowing buyers to exercise DNE. After that, the resulting positions from the options may be closed in futures on the expiry day till the end of the day or the resulting options will be settled by delivery. So on the futures expiry day, no stock options will trade. Such conversion of options into futures is prevalent in CME, NYEMX, and MCX.

 Another alternative model is also proposed, which suggests allowing DNE for contracts that were OTM as per the last traded price (LTP) at the close of market hours and became ITM due to settlement price computation.

The matter was deliberated widely in a SEBI committee comprising brokers and officials of clearing corporations and exchanges.

The history of DNE 

The DNE facility was introduced in August 2017, considering that certain ITM option holders were having negative payoffs due to the incidence of STT on the settlement price of the underlying (notional value).

From September 2019, STT began to be levied on the intrinsic value of the option instead of the settlement price. With this change in the computation of STT, the concerns related to negative payoff, were no longer relevant since STT was levied on the intrinsic value (profit) of the option thereafter the DNE facility was discontinued in October 2021.

But in the absence of a DNE facility upon the expiry of stock option contracts, and the mandatory requirement of physical settlement of stock derivatives, if an OTM option suddenly turns ITM on the expiry day, the same poses the obligation on such ITM option holder to bring in the cash or securities to honour the physical settlement. If the position is large enough, that may pose a big problem.

While restoring the DNE facility, as an interim measure, in April 2022, to mitigate the above risk, it was decided to examine or explore policy on net settlement of the cash segment and F&O segment upon expiry of stock derivatives in order to bring about a structural reform which while addressing the above concern should also further strengthen the alignment of cash and F&O market.

With the objective to provide better alignment of the cash and derivatives segment, the mitigation of price risk, and bringing in netting efficiencies for market participants, SEBI decided to introduce the net settlement of the cash segment and F&O segment upon expiry of stock derivatives. The same came into force from the March 2023 expiry of F&O contracts.

In December 2021, because of the lack of DNE facility, traders were forced to deliver Hindalco stocks as Hindalco 450 PE expired just in the money at Rs 449.65, and traders who had long puts were forced to deliver or face the consequences. Some of the traders were forced to crowd-fund to make up for the delivery. Thereafter, the DNE facility was restored.