Sebi's new steps to reduce risks in F&O trading

The fresh proposals may not materially affect traders but could help reduce the frequency of stocks entering the ban period, thereby simplifying their trading experience. The changes also aim to enhance market integrity and ensure a more accurate reflection of market conditions.

The Securities and Exchange Board of India (Sebi) has proposed a raft of new measures aimed at reducing risks and the potential for manipulation in the equity derivatives market while ensuring a stronger alignment with the cash market.

Key proposals include a new methodology for calculating open interest (OI) using a 'delta' framework, a review of marketwide position limits (MWPL), and the introduction of position limits for single stocks and index derivatives.

The new proposal comes close on the heels of six measures introduced by Sebi to curb frenzy in index derivatives.

These measures -- a majority of which have already been implemented -- have nearly halved trading volumes.

The fresh proposals may not materially affect traders but could help reduce the frequency of stocks entering the ban period, thereby simplifying their trading experience. The changes also aim to enhance market integrity and ensure a more accurate reflection of market conditions.

The market watchdog has proposed a new metric called 'future equivalent' or a delta-based framework for calculating open interest in futures and options (F&O).

Delta refers to the change in an option's price when the price of the underlying security changes in the cash market.

At present, open interest (OI) is measured by adding notional OI in futures and options. OI is key to gauging trader activity and sentiment.

"A more meaningful approach would be to aggregate the delta or future equivalent of options positions with futures OI, thereby reflecting the true price sensitivity of outstanding positions," observes the consultation paper.

Sebi also plans to link MWPL to the underlying cash market.

MWPL refers to the maximum number of open F&O contracts allowed for a single stock.

Once a scrip exceeds MWPL, further trading in its derivatives is restricted. The regulator has proposed a mechanism to offset trades instead of merely squaring off positions when a stock enters the ban period. The move is intended to help traders reduce their risks.

For instance, if a trader holds a long futures position, they could buy put options or sell call options to reduce total delta exposure.

Currently, MWPL for each stock is 20 per cent of the stock's free-float market capitalisation (mcap) and is applied to the total notional OI of F&O.

Sebi has proposed reducing it to 15 per cent of free-float mcap or 60x the average daily delivery value (ADDV) in the cash market, whichever is lower. This metric will be recalculated every three months based on rolling ADDV.

The new methodology is expected to reduce instances of stocks moving into the ban period by 90 per cent.

The regulator may also explore the need for an MWPL for index derivatives in the future.

The new methodology will also be incorporated when considering exposure limits for mutual funds (MFs) and alternative investment funds in derivatives to ensure that it accounts for leverage in long options.

Further, Sebi is considering imposing individual entity-level position limits for single scrips so that no single entity, such as a foreign portfolio investor (FPI), stockbroker, or MF, can unduly influence the market.

Sebi has proposed increasing the end-of-day limit for index futures from ₹500 crore to ₹1,500 crore, considering the rise in market size and trading volumes since March 2020. The intraday limit for the same has been proposed at ₹2,500 crore to facilitate market-making.

Similar revisions have been proposed for index options as well.

Another key proposal is introducing pre-open and post-closing sessions for derivatives, similar to those in the cash market, to enhance price discovery.

"This is especially useful, as today there are fewer than 40 stock options with complete liquidity and fewer than 25 that can be traded at a scale of a few hundred crores. These reforms put in place a basis for a more efficient, open derivatives market, but they will succeed only if investors and traders learn to adapt to the new regime," said Rahul Ghose, chief executive officer of Hedged.in.

Further, Sebi has proposed additional conditions to allow derivatives for sectoral and thematic indices. Such an index must have at least 14 constituents, with the weight of the top constituent not exceeding 20 per cent and the combined weight of the top three not exceeding 45 per cent.

The clarity will help exchanges offer derivatives on more indices.