Saturday, October 30, 2010

Introduction of European Options in Stocks. (What will change)

SEBI came out with a circular on 27th November, 2010 giving freedom to Stock Exchanges for choosing style of Options (European / American) on Stocks. It gives flexibility to stock Exchange to offer either European style option or American Style Options.

Options were introduced in 2001 in Indian markets and SEBI had made it mandatory that all Index Options have to be European Style options and all Stock Options should be American style option.

Now SEBI has given liberty to Stock Exchanges to decide on the types of Options, they intend introducing on Equities.

A day after, SEBI issued these circular, NSE on 28th November, 2010 came out with a circular stating that NSE has decided to introduce European Options on Stocks instead of American Options on Stocks. The implementation date of such change is from January, 2011 contracts which were to be introduced for trading the following day 29th November, 2010.

There are different issues to be discussed on this move :
a) What will change ?
b) Why was there a sudden and abrupt change ? 
c) How would it impact trading  and Volume ? How would there be change in value of Options?

A) What will change ?

American Options provided right to holder of Options to exercise the options on any trading day during the life of option, whereas in case of European options, the holder can exercise his right only on last day of options (Expiration day).

With Exchange introducing European stock options for Jan,2011 series, Investor will have to understand that they can not exercise their options before the expiration date, nor would there be assignment of any options.

It means they can only sell or buy such options to liquidate their positions, but there will be price (premium / discount) for deep in the money calls and puts. It simply means there will be higher cost on liquidating of positions.

Optimal Exercise of  Calls are before the Ex dividend date and Puts are optimal to exercise as they become deep in the money, but with introduction of European options , things would become simpler but will would also mean that the prices would not deal with all dynamics of market pricing (like Dividends, Open offers, Buy Back).

So when you want to trade in stock options from January, 2011 contracts, you will have to search


You will have to search using CE (call European) and PE(Put European), instead of CA (Call American/ Put American)
We will discuss change in valuation of option in part C.

b) Why was there a sudden and abrupt change ?

NSE took a prompt decision to implement to introduce European Options in one day. SEBI circulars says that such decision was taken after taking views from Stock Exchanges.

SEBI must have given this flexibility to stock Exchanges as they may have felt that Risk management mechanism of Stock Exchanges are robust and it is perfectly operational. I don't think SEBI has taken views about it from all categories of market participants and I guess most of them must be unaware of such development.

There is also no clarification on the reason for change ?  Was it demanded by some section of participants ? or was some empirical studies done before such move ? Was it a proposal from Stock Exchange ?

Overall Risk Management committee of SEBI insisted on American Options on Equities, when it was introduced  in 2001 ? It was suggested by SEBI and leading academicians of the country in this field.

What is the rationale of such order by SEBI now ?

Further SEBI would have expected  from Stock Exchanges to get feedback and discussion for its participants. but how would NSE have taken a view from market participant when they just implemented it in a day.

Why was there a rush to implement such move ? Was there any compulsion from section of market participants ? Have NSE done any empirical studies for such move ?

SEBI guidelines say that, Once Exchange decides the change in Style of  stock options, they have to take permission from SEBI regarding the same and also they have to inform the general public about the change, at least before one month of implementation. Has NSE failed in following SEBI guidelines. Maybe they would have got the SEBI approval in a day but One month notice to all stake holders and Public. I guess they have missed (January, 2011 contract was introduced from 29th November, 2010.)

In fact Exchange should have put up a proposal for change in style of options and invited public opinion, before its implementation.

My view about  this NSE move is that it is only to accommodate certain section of participants and to garner higher volumes. They are not interested in the price discovery process.

I perceive FII's are very active in Index Options but they are not very active in Stock Options. The probable reasons could be higher volatility in stock futures, lower liquidity in stock futures, lower market wide open limits in stocks. But I am sure FII's deal with such situations in all geographies.

There are more than 224 stocks on which Options are allowed in India. If you are a fund manager sitting in different geographies and managing funds in many geographies, it would be tough to track optimal exercise / assignment probabilities on all stocks (If the Options are American).

Though Stock Options in developed Geographies like America and Europe are American options, Such players may have suggested that it is difficult to track all stock options for optimal exercise and probability of assignment and hence FII's may not be trading in Stock Options in India.

In order to woo FII's and help them get away with complex calculation of valuing and monitor American stock option, NSE must have implemented European stock options. 

SEBI guidelines Indian Institutions as of now are not allowed to write options, they can only buy options. Will such a move give FII's an edge.

Also I am not sure, how would market wide position limit impact such options. Because if holder of option cannot exercise his rights and he cannot find a buyer (Not because nobody wants to buy, but they cant because of market with open limit). Worse if somebody is short and wants to cover, when it is in ban period?

 It may increase the volume on NSE  and income in long run, but I guess we will miss on price discovery process as European options can be easily calculated using Black -Scholes model ,( where the reality of dividend, open offers and buy back does not exist)

We will be trading on raw product where many market dynamics are absent, I guess NSE should have introduced Options on Stock Futures (Futures options) instead of Stock Options.

I hope NSE has done its homework and does not have to take a step backwards, as in the case of introduction of Derivatives instruments on GoldBees, where they have to cancel such introduction after making the announcements (incidentally NSE did not bother to take participants view on that move also).

c) How would it impact trading  and Volume ? How would there be change in value of Options?

With introduction of European options, Exchange must be expecting the rise in options volumes. They may be banking on the participation of FII in market making in Stock Options also. I expect that this move may create higher volumes as these are simpler products compared to American Options.

But different strategies prevailing in markets will vanish or will become unviable.

We will now try to discuss some changes in valuations and Strategy.

The Basic difference between American and European Options is timing of Exercise. American Options can be Exercised any time during the life of options, but European options can be exercised only on Expiration day.

European options are comparatively easier to value using Black Scholes models, where the models takes in to consideration the final price and not the path it moves before such price. Its basic assumption is there are no dividends on the stocks. But that's a myth in real world. 

We will see the changes in upper boundary and lower boundary of options.
Boundaries are the maximum and the minimum price of an option.

American Option
European Option
Call lower  boundary
Spot price – Strike price

Spot Price – Strike Price + Cost of carry
Futures Price  – Strike Price + Cost of carry(Options Price only)

Call upper boundary
Price of Stock
Price of Futures (No Matter if Stock Price is Higher or Lower)
Put  lower Boundary
Strike price – Spot price
Spot price – Strike Price – Cost of Carry
Strike Price – Futures Price – Cost of Carry
Put  upper Boundary
Strike Price
Strike Price – Cost of Carry

From the above table ( I have tried to be as simple and not bring in formulas or signs), we can see that there will be higher impact of cost of carry on option prices. In simple words Calls will become costlier and Puts will become cheaper. Put may be available below their intrinsic value but it has to be carried and cannot be exercised. Calls will remain costly and you wont be able to exercise, if it becomes deep in the money (No doubt you can sell it , but there will be problem of liquidity in such strikes).

In India,  Stock futures are not entitled for dividends (unless it is more than 10% of stock price) and hence they are quoted at a discount to spot price to the tune of dividend and on Ex dividend date the stock price falls by the amount of dividend and again the difference between spot price and futures price is cost of carry.

Next would be impact of dividend on options. As of now all in the money calls were exercised (where Put price was less than dividend) on the eve of stock going  Ex - dividend. That was the reason of higher option price. European options cannot be exercised before expiration date and stock may go Ex dividend during the life of option which may reduce the price of call as dividends cannot be optimised on European options.

Also there will be optimal exercise in cases of buybacks and open offers. Calls can be exercised on last  day of trading where the stock can be bought in cash market and buyers can participate in such offers.
Also I perceive that calls price and put prices will fall, ( Technically Implied volatility will reduce)  because theoretically Europeans options are cheaper than American options.

To summarise price of options may fall (Lower IV), but Options needs to be carried till expiry (you can sell it).

When you look at price of option, don't look at Spot price of stock, but look at its futures price and value it accordingly.

I welcome your suggestions and critical comments.

Tuesday, October 12, 2010

Introduction of Pre Opening Session on NSE

Further to my blog on Pre-opening session and SEBI guidelines,
NSE came out with guidelines on Pre opening session.
There will be Pre - Opening session on National Stock Exchange of India Limited (NSE) from 18th Oct, 2010 for determination of credible opening price.

The Key takeaways and Precautions of this circulars are as follows :

a) Pre Opening session is meant to discover opening prices thereby reducing volatility in price at the open of the market. Initially only only Nifty and Sensex stocks are included in Pre opening session, but eventually Pre opening session will be there for all stocks, when the systems is stabilised and running without hindrance or improper price computation (Pre Opening session was there in India in 1999, but It was discontinued after instances of flaws in price computation algorithm)

The Pre Opening Session is there only in Cash Market and there will not be a pre opening session in Derivatives market. 

b) The Pre opening session will start at 9.00 am and will close between 9.07am  to 9.08 am randomly to avoid and foul play at last moment. The normal Cash market will start at 9.15 am after getting confirmation of trades in pre opening session. There is no clarity on change in timing of derivatives market, but I guess F & O market will also start from 9.15 am.

c) There will be a separate book for pre opening session in market. It will be called as PO, So if you wanna trade in Pre opening session you will have to trade in PO book (EQ : Normal Equity , BE : Trade to Trade Stock) and than during normal market trading will take place in EQ book.
All pending orders which are not matched in Pre opening session will be automatically transferred in normal market. The un executed market orders will be transferred as limit orders at opening price.

d)  Order Matching Logic. : The order matching logic in pre opening session is as follows, The priority will be given to limit orders, and than the market orders (It is reverse of what was there in earlier Pre opening session). First all limit orders will be taken or price computation and traded, if there is any unmatched quantity , market order will be considered on both sides and then market orders will be matched with market orders at equilibrium price  (Opening price)

My sincere suggestion, Try to put limit orders for better execution.

e) The opening price will be the equilibrium price at which the maximum quantity of trades can take place. If there are 2 equilibrium price in computation, than the price which is closer to closing price will be taken as opening price. 

In case of Only market orders, the previous day closing price will be takes as opening price and if there are no trades in pre opening session than first trade in normal market will be taken as opening price.

f) All un-executed orders will be transferred from pre opening book to Normal market, limit orders will be limit orders and pending market orders will be limit orders at opening price or previous days closing price, what ever the case may be. 

All pending order will have price / priority based on pre opening session time stamp.

g) The Risk management structure will be same as normal market.

It is a good move by SEBI, in reducing market micro structure impact in price discovery process.

But there are some unresolved issues , which I am sure will be resolved on later date, 

i) What will be the opening time for Derivative market segment ? 9.00 am or 9.15 am. ?

ii) There will be impact on price discovery process and there are higher volumes on Derivatives market and market will have to wait for opening session to be over and then only position on Derivative market can be cleared after seeing the opening price on Cash segment. But academically it is found that there  exist lead - Lag relationship between derivatives market and Cash segment and Derivatives market takes the lead and Cash Segment lags behind.

In such situation there lies a probability that there will be a opening price in Cash segment, but Derivatives market may show a different price (In terms of Percentage change from closing price after considering cost of carry for n days). In such case Cash price will immediately drift from opening price to price discovered in Derivatives market. (Only time will say about this behaviour) 

iii) Market orders are meant for prompt execution, whereas it carries a disadvantage in pre opening session, In fact we cannot term it as a way to get cut-off because you are not assured of a trade at opening price. 

It may be advisable for SEBI to disallow market orders in pre opening session as they have disallowed disclosed quantities.

I will update to BSE process of Pre Opening session , after BSE come out with the guidelines.

I welcome your critical comments and suggestion.