You have the option of containing risk

SEBI has specified the following risk-containment measures to be adopted by the derivative exchange/segment and the Clearing House/Corporation for the trading and settlement of both Index Option Contracts:

*The Index option contracts to be traded on the derivative exchange/segments shall have SEBI's prior approval. The contract should comply with the disclosure requirements laid down by SEBI.

*Initially, the exchanges shall introduce premium style index options.

*Initially, the exchanges will introduce European style Index Options which shall be settled in cash.

*The Index Option Contract shall have a minimum contract size of Rs 2 lakh at the time of its introduction.

*The Index Option contract shall have maximum maturity of 12 months and shall have a minimum of three strikes (in the money, near the money and out of the money).

*The Initial Margin requirements will be based on worst case loss of a portfolio of an individual client to cover a 99 per cent VaR over a one-day horizon. The Initial Margin requirement shall be netted at level of individual client and it shall be on gross basis at the level of Trading/Clearing Member. The Initial margin requirement for the proprietary position of Trading/Clearing Member shall also be on net basis.

*A portfolio-based margining approach shall be adopted which will take an integrated view of the risk involved in the portfolio of each individual client, comprising of his positions in index futures and index options contracts. The parameters for such a model should include:

What is worst loss? The worst case loss of a portfolio would be calculated by valuing the portfolio under several scenarios of changes in the index and changes in the volatility of the index. The criteria to be used would be:

*The price range is defined to be three standard deviations as calculated for VaR purposes in the index futures market for the near-month contract.

*The volatility range would be taken at 4 per cent for six months, after which it shall be reviewed.

*While computing the worst case loss, it shall be assumed that the prices of futures of all maturities on the same underlying index move up or down by the same amount.

*For the purpose of the calculation of option values, the exchanges may use any of the following standard Option Pricing Models -- Black-Scholes, Binomial, Merton, Adesi-Whaley.

*The maximum loss in any situation (considering only 35 per cent of the loss in case of scenarios 15 and 16 in the Table) is referred to as the Worst Scenario Loss.

Subject to the additions and adjustments mentioned below, the Worst Scenario Loss is the margin requirement for the portfolio.

Calendar spread: The margin for calendar spread would be the same as specified for the index futures contracts. However, the margin shall be calculated on the basis of delta of the portfolio in each month. Thus, a portfolio consisting of a near-month option with a delta of 100 and a far-month option with a delta of -100 would bear a spread charge equal to the spread charge for a portfolio which is long 100 near month futures, and short 100 far month futures. The Calendar Spread Margin would be charged in addition to the portfolio's Worst Scenario Loss.

As in the index futures market, a calendar spread would be treated as a naked position in the far month contract as the near month contract approaches expiry. In the index futures market, this is done in gradual steps over five trading days. For the sake of computational ease, it is now decided that when options are introduced, the gradual steps would be eliminated. Therefore, a calendar spread would be treated as a naked position in the far-month contract, three trading days before the near-month contract expires.

Short option minimum margin: The short option minimum margin equal to 3 per cent of the Notional Value of all short index options shall be charged if the sum of the Worst Scenario Loss and the Calendar Spread Margin is lower than the, Short Option Minimum Margin.

Net option value: This value will be calculated as the current market value of the option (positive for long options, and negative for short options) in the portfolio. The Net Option Value shall be added to the clearing member's Liquid Net Worth. This means the current market value of short options will be deducted from the Liquid Net Worth and the market value of long options will be added thereto.

Thus, mark-to-market gains and losses on option positions will get adjusted against the available Liquid Net Worth. Since the options are premium style, mark-to-market gains and losses will not be settled in cash for option positions.

Cash settlement of premium: For option positions, the premium shall be paid in by the buyers in cash and paid out to the sellers in cash on T+ 1 day.

Unpaid premium: Till the buyer pays in the premium, the premium due will be deducted from the available liquid net worth on a real-time basis.

Cash settlement of futures mark-to-market: The mark-to-market gains/losses for index futures position shall continue to be settled in cash.

Position limits: The position limits in the index futures market will be applicable to index options also on the basis of notional value.

Real-time computation: The computation of Worst Scenario Loss has two components. The first is the valuation of each option contract under 16 scenarios using an appropriate option pricing model. The second is the application of these Scenario Contract Values to the actual positions in a portfolio to compute the portfolio values and the Worst Scenario Loss.

For computational ease, exchanges are permitted to update the Scenario Contract Values only at discrete time points each day. However, the latest available Scenario Contract Values would be applied to member/client portfolios on a real-time basis.

Option on individual securities

Introduction of options on individual securities will help investors protect against market risk in the equity market by hedging, and also increase the capital market's liquidity and efficiency. It will also facilitate further development of human capital in the skills of market participants.

The SEBI technical group on new derivatives product is discussing the various parameters for introducing options on individual securities. Securities within the range of stipulated volatility and which fulfill specified criteria of liquidity, trading frequency, market capitalisation, and free float will be selected for introduction of options. The broad criteria will be:

*Stock should figure in the list of top 200 securities, on the basis of average market capitalisation, over the last six months and average free float market capitalisation should not be less than Rs 750 crore. Free float market capitalisation means the non-promoter holding in the stock; and

*Stock should appear in the list of top 200 securities, based on the average daily volume, over the last six months. Further, average daily volume should not be less than Rs 5 crore in the underlying cash market; and

*Stock should be traded at least on 90 per cent of the trading days, during the last six months; and

*Non-promoters holding in the company should be at least 30 per cent; and

*Ratio of the stock's daily volatility vis-a-vis daily volatility of index should not be more than four, any time during the previous six months. Volatility estimates would be computed according to the Prof J. R. Varma Committee report on risk-containment measures for index futures.

On the above criteria, it is estimated that 30-35 securities would qualify for options trading. The eligibility criteria would be reviewed after six months to examine whether in the light of the experience, the list of eligible stocks could be expanded.

As a part of risk containment, the SEBI group also decided to impose limit on the overall open interest in options on individual securities. It was decided that open interest in terms of number of stocks should not exceed 20 times of the average of daily shares traded, during the previous calendar month, in the underlying cash market.

The eligibility criteria will be reviewed after six months to examine whether the eligible securities could be expanded. The group has also decided that for an initial period of six months, options on individual securities would be cash-settled and the exchanges would adopt delivery-based settlement.

(Edited-extracts from the latest NSE News published by the National Stock Exchange of India. The author is Mr R. Sundararaman, Head -- Futures and Option Segment, NSE.)