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.

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