Introduction of Futures and Options on Global Indices on NSE

As per SEBI guideline and permission, NSE is set to launch Futures and Options contracts on " S&P 500" and only futures contracts on "Dow Jones Industrial Average" (DJIA).

Now instead of Tracking these indices and taking queue over here, we might as well trade on such indices or hedge on such indices.

Before discussing the impact of such indices, let us understand its features.

S & P 500 DJIA How it will show on NSE F&O Screen FUTIDX S&P500 FUTIDX DJIA Lot Size 250 25 No of Contracts available 6 6 M1, M2, M3,Q2,Q3,Q4 M1, M2, M3, Q2,Q3,Q4 Expiry 3rd Friday of Every Month 3rd Friday of Every Month Last Trading Day Same day as Expiration Same day as Expiration Settlement Cash Settlement Cash Settlement Underlying Currency Indian Rupees Indian Rupees Types of Option European Not available Margins Span Margin Span Margin Settlement Price Opening Price of S&P 500 on CME Opening Price of DJIA on CME There are several Advantages of trading in Global Indices in India They are mentioned as below a) S&P 500 would be traded on stock Exchange outside USA for the first time. This would also enable many FII to take position in India but as of now only Resident Indians as per SEBI guidelines can trade. b) This will enable investors to take positions or Hedge on International markets. c) Simplicity : It is simple as we trade in nifty as the underlying is traded in Indian rupees. There is no currency exposure. d) Easy Access : It will give easy access to all investors in every part of the country. e) There is a facility to see live quotes of CME to take position. f) There is trade and settlement guarantee fund of NSE, which will enable security of our settlement. g) New strategies can be introduced in market based on Nifty, DJIA & S&P 500 and its movement and correlation h) Updates on development in these index will help up see broad trends of industry globally. i) There are benefits of cross-margin between  DJIA and S&P 500. There are some thing to be understood before trading a) You will have to pay taxes and STT as per Indian law only. It may lead to price distortion between prices in India and abroad. b) The Settlement price of these contracts are computed based on opening price of all its stocks. That is termed as SOQ( Special Opening Quotations). Please understand that opening price of Index is not same as SOQ price. there is a slight difference.      Normally when market opens we get quotes and opening prices at the open of trading but there would be some stocks which will trade after some time may be minutes or after an hour. In the meantime there may be many prices which would have been derived on DJIA and S&P 500. What SOQ does is, it considers opening prices of all its constituents, (though they may have been traded after some time) and derive a opening price such price is called as SOQ prices which would be the final settlement (we will discuss more on rationale of SOQ later).     What it also means that if you have position at the close of settlement, you are not aware of the settlement price till the opening of American markets and then only you will know the settlement price which may be different from Dow futures or S&P futures which you may see our market times. c) Initially there wont be participation of FII in these segment of market and as such there wont be a live trading on underlying which may result in illiquidity, higher bid-ask spread, outlier trades. d) Trading in DJIA and S&P is almost 23 hours, because there are 2 types of trading on CME. a) Pit Trading and Globex (Electronic Trading. These electronic trading system is open for 23 hours.) but there will be problem of liquidity on these exchanges at odd hours (when there is night is USA and we Trade.) To sum it up, it add one more tool for trading in our arsenal but we may play blind bets on overnight positions where there will be volatility in that market and the price will change over there and we will only be the price taker at the open of trade over here. Some more FAQ, if you are not bored : a) How do we trade : It is on individual preference, but as mentioned price discovery on underlying will take place only in American markets, when our markets will be closed. The initial strategy would be to trade by taking positional view on these index (may be for 3 - 4 days) or create a hedge for position in Indian assets. b) Why is the final settlement at the opening price ?                                              There are market makers / Specialist in that markets appointed by the companies and Exchanges. These market makers / Specialist are obliged to give quotes during the day and absorb all demand and supply of individual stocks. So when the market opens these people absorb all demand and supply at the opening price with the obligation to make sure that there is lowest possible drift from previous closing price. Because of these, arbitrageurs in that market who have positions between underlying and Index buy / Sells at opening price to track SOQ prices. Opening price in such markets is a good indicator.(of overnight information change, overnight  liquidity needs and Noise (Fama))These prices are equilibrium price as it absorbs all demand and supply at the open.and If we compute the opening prices of all such underlying stock we get SOQ which is perceived to be a good and equilibrium opening price. Many other exchanges in America (like CBOE) use SOQ prices for settlement. c) How about trading in Options : You can trade in options only on S&P500. The queue of Implied volatility will come from CME only and the would be little higher in India (because of Illiquid Indian markets for these products)  .     In the Money calls will be cheaper (because of higher STT on Exercise). Also the cost of adjustment will be higher because of bid  ask -  spread. I welcome your comment, suggestions and queries.

Hike in Investors application amount in retail category : A Boon or Bane ?

SEBI has reserved 35 % of the IPO for Retail Investors. An Investor intending to apply under the category of Retail Investors can apply for not more than Rs 1 lakh. but Since November, 2010 SEBI has increased the limit to Rs 2 lakhs. Now Investors can apply in IPO under Retail category for up to Rs 2 lakhs.

The biggest appeals in applying under retail category are

a) Investors may get discount of 5% on IPO price in case of PSU IPO.

b) With recent SEBI guideline, IPO is open for one extra day for only retail Investors to apply. Hence Retail Investors can apply after looking at the appetite on HNI and Institutional Investors.

c) There is probability of getting higher allotment.

SEBI has increased these limits after 5 years, to cater to demand of investors for higher participation in IPO. 

The advantages perceived by SEBI with increase in Retail limit are

a) Higher amount of participation by Retail Investor.

b) Higher Allotment in retail category.

c) Wider appeal to Investors.

d) Option to Apply after closing of bids for HNI and Institutions.

But does it mean that doubling the limit will lead to doubling of absolute returns ?

Below is the application status of recent IPO with Retail  application limit of Rs 2,00,000/-. Along with is the  probability of allotment, in case the application amount would have been Rs 1,00,000/- only

Name of Co	Issue size (Retail)	Retail Limit	Subscription	Prob of Shares allotted	Cost of Fund @8% for 15 days	Retail Limit	Subscription	Prob of Shares allotted	Cost of Fund @8% for 15 days
MOIL	11524800	2lacs	32.86 times	17	657.53	1lac	18 times	17	328.7
SCI	29493547	2lacs	6.56 times	600	657.53	1lac	4 times	550	328.7

In above table, We find that increase in Retails limit leads to no increase in allotment or there is marginal increase, wherein there is also rise in interest cost whereas Opportunity cost is not considered.

I would request you to read below mentioned points for the answer

a) Who will take advantage of this limit hike ?

I think the Investors who were investing for Rs 1,00,000/- will only hike their limit to 2,00,000/-. We will get the rationale of this view by looking at the subscription pattern in retail segment. Most of the applications are at upper limit leading us to infer that most of such investors have surplus and they invest up to maximum limit and thus when the limit is hiked many of them would apply for higher amount.

I also don't think that Investors applying for Rs 2,00,000/- in HNI category will apply in Retail category (Because looking at past data , the returns by applying for Rs 1,00,000/- was more than applying in HNI for Rs 2,00,000/-.)

There is a grey market for application where the investor applying in retail category get lump sum amount irrespective of returns for IPO. The prevalence of such market indicates that there is appetite for higher amount of retail category. so if the limit is hike people would put in higher amount.

b) After inferring that people who were applying in IPO in retail category for Rs 1,00,000/- will in all probability apply for Rs 2,00,000/-.

But would that mean that allotment will be double with increase in limit. but I really feel that allotment would be somewhat more than half of what was allotted previously. To understand this rationale we will look at some examples

i) In past 6 months most of the IPO are over - subscribed by more than 1 time in retail category except in few cases where it was under subscribed because of lower quality of issue and not because the size was big and limits of Investors were exhausted.

ii) The MOIL issue was oversubscribed 32.86 times in retail category. The Investment limit in retail was Rs 2,00,000

iii) The SCI issue was oversubscribed 6.56 times in retail category. The Investment limit in retail was Rs 2,00,000

iv) The Claris Life Science issue was oversubscribed 1.60 times in retail category. The Investment limit in retail was Rs 2,00,000. This issue was not subscribed because of Higher IPO price, in fact they have reduced the IPO price.

In the above scenario if the Limit would have been 1,00,000 /- I guess the subscription times would be almost 50 % (Eg 18 times for MOIL, SCI at 4 times). but the number of shares allotted would have been same.

In fact we are blocking twice the amount and receiving the same quantity of shares thereby reducing our returns in percentage terms by 50%.

d) We should also consider the opportunity cost of extra 1,00,000/-. Funds are scarce resource, if that amount is invested in another issue,maybe the returns would be higher.

Does that mean Such Limits should not have been relaxed ?

No, The limits should have been relaxed in Slabs. If the Issue size is large enough to handle bigger amount, than only 2,00,000 / - limits should be applicable. For Example issue for more than Rs 2000 Cr or 3000 Cr in Retail category. Such Slabs will ensure higher retail participation for bigger issues and smaller issues will ensure lesser blockage of funds. Also leading to lesser logistical hurdles.

I welcome your critical comments and suggestions.

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

FUTSTK : STOCK NAME : MONTH :  STRIKE PRICE  : CE/PE

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 Or 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 Or 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.

Introduction of Pre Opening Session on NSE

Further to my blog on Pre-opening session and SEBI guidelines,

http://gandhijigam.blogspot.com/2010/07/introduction-of-call-aution-for-opening.html

http://gandhijigam.blogspot.com/search/label/pre-opening%20session

  

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.