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THE universe of eligible stocks would vary from month to month as the impact cost and the quarter-sigma order size are calculated every month on a rolling basis considering the previous six months. It is therefore necessary to lay down the procedure for introducing and dropping stocks:

* Options and futures contracts may be introduced on new stocks when they meet the eligibility criteria. Mr Vaidyanath is of the view that contracts should be introduced on new stocks only when they meet the eligibility criteria for three months in succession.

* If a stock fails to meet the aforesaid eligibility criteria for three months consecutively then no fresh month contracts should be issued on that stock. However, the existing unexpired contracts may be permitted to trade till expiry and new strikes may also be introduced in the existing contract months.

* However, the Exchanges should be empowered to compulsorily close out all derivative contract positions in a particular underlying when that underlying has ceased to satisfy the new eligibility criteria and the exchanges are of the view that continuance of derivative contracts on these stocks would pose a threat to market integrity and safety.

* If the impact cost for a stock moves from less than or equal to 1 per cent to more than 1 per cent, the price scan range in such stock should be scaled up by 3 and the scaling should be dropped when the impact cost drops to 1 per cent or below. Such changes should be applicable on all existing open position in the underlying from a pre specified date.

* For the purpose of computing 1.5 standard deviations, the standard deviation of the daily logarithmic returns of prices in the scrip during the last six months would be computed. This value would be applicable for a month and would be recalculated at the end of the month by once again taking price data on a rolling basis for the past six months.

The Committee would like to lay down some guidelines on the actual computation of impact cost and quarter sigma order size:

* Impact cost and the quarter sigma order size should be calculated by taking four snapshots in a day from the order book in the past six months. These four snapshots should be at times randomly chosen from within four fixed ten-minute windows spread through the day. The Exchanges should work together and use a common methodology for carrying out the calculations. Further, for a stock, lowest impact cost across any exchange in India would be considered.

* The details of calculation methodology and relevant data should be made available to the public at large through the web sites of the exchanges. The recommendation that SEBI should only lay down the broad eligibility criteria for stock derivatives needs to be reconciled with the role of SEBI in approving derivative contracts under paragraph 4.10 of the LCGC report:

"The Committee suggests that before starting trading in a new derivatives product, the derivatives exchange should submit the proposal for SEBI's approval, giving (a) full details of the proposed derivatives contract to be traded (b) the economic purposes it is intended to serve (c) its likely contribution to the market's development and (d) the safeguards incorporated to ensure protection of investors/clients and fair trading. SEBI officers should be in a position to provide effective supervision and constructive guidance in this regard."

Properly interpreted, there is no contradiction here. What is being said in this report is that SEBI should take a view that stock futures and options contracts on stocks meeting the broad eligibility criteria would normally meet the tests laid down in paragraph 4.10 of the LCGC report and it would not be necessary for SEBI to apply its mind ab initio to each such contract that is proposed by an exchange. However, SEBI would retain the right under exceptional situations to deny permission for a contract that meets the eligibility conditions if it has particular reason to believe that clause (d) of paragraph 4.10 would not be met in that particular case.

If you have any queries relating to the futures/options markets and strategies that can be used in these markets, please mail them to Futures & Options, Kasturi & sons, 859-860, Anna Salai, Chennai 600 002 or email them to vaidy@thehindu.co.in with a mention of futures/options in the subject line of the mail.

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