Is this not the right time to introduce circuit filters for derivative stocks too?

KS Badri Narayanan Chennai | Updated on September 28, 2018 Published on September 28, 2018

Many investors have been wiped out in just a day by the YES Bank, Infibeam and DHFL crash

On Friday, it was the turn of Infibeam to give investors a nasty surprise.

The stock plummeted over 70 per cent, almost wiping out 3/4th of its starting market value for an investor in a single day. Last week, it was the turn of YES Bank to face the sellers’ wrath; the stock plunged 30 per cent in a single day. The previous week, it was DHFL, the share price of which crashed by almost 50 per cent. And a host of housing finance companies wiped out investors’ wealth to the extent of 7-30 per cent. Some lay investors may wonder how these stocks had a free fall, and no circuit breaker was applied. According to the exchange rules, no circuit filters are applicable on stocks on which derivative products are available. Stocks that are part of an index on which derivative contracts are trading also don’t carry circuit filters. However, exchanges do impose a 10 per cent dynamic circuit filter on these securities, to avoid punching in errors while trading.

One of the reasons why these stocks do not attract circuit filter is that it will affect fair price discovery for a scrip. As only highly liquid and active stocks are part of the futures and options segment, it is best to allow the market to discover the right price for such stocks, is the conventional wisdom. Stock are chosen for the futures segment from among the top 500 stocks based on average daily market capitalisation and average daily traded value in the previous six months on a rolling basis. Besides, there is a bunch of norms to check liquidity.

The stock’s median quarter sigma-size (average of median buying and selling price) should not be less than ₹10 lakh. For this purpose, a stock’s quarter-sigma order size would mean the order size (in value terms) required to cause a change in the stock price is equal to one-quarter of a standard deviation.

The criteria also say that the market-wide position limit in the stock should not be less than ₹300 crore. The market-wide position limit (number of shares) shall be valued taking the closing prices of stocks in the underlying cash market on the date of expiry of contract in the month. The average daily delivery value in the cash market should not be less than ₹10 crore in the previous six months on a rolling basis. The average daily deliverable value is computed taking deliverable quantity at the client level.

However, recent declines show that the bourses and SEBI need to tighten the rules further, both for allowing some stocks into the F&O segment as well as to check their extraordinary price movements. After all, if these stocks were highly liquid, they would not have fallen this much in a single session. To correct this, one idea is to restrict the F&O trading to the top 50 or 100 scrips without applying such criteria.

Don’t over-leverage

To curb volatility, why not have circuit filters even on stocks featuring in F&O? In fact, SEBI, in 2012, had mooted a dynamic price band of 10 per cent for those scrips and indices on which derivative products are available and for index and stock futures segment to prevent “aberrant orders or uncontrolled trades”.

Is this not the right time to take a relook at the liquidity criteria? Maybe it is time to bring in a circuit filter to F&O scrips too, such as in the cash segment.

Retail investors can mitigate their losses by not over-leveraging or stretching their finances. They must avoid entering F&O without understanding the MTM concept.

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Published on September 28, 2018
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