Markets

Will compulsory delivery impact F&O trading?

KS Badri Narayanan Chennai | Updated on June 29, 2018 Published on June 29, 2018

Beware: Liquidity risk by way of significant margin and capital costs could hurt you

Be prepared to have enough money in your account if you want to trade in the 46 F&O stocks that have been moved to the compulsory delivery category by the NSE starting July. This follows the SEBI diktat in March to align the cash and derivative segments of the market, through physical settlement for all stock derivatives in a phased and calibrated manner. To start with, the NSE has initiated compulsory delivery in 46 stocks.

Among the stocks now requiring compulsory delivery are Adani Power, BEML, Berger Paints, CanFin Homes, CG Power, CPCL, DCB Bank, Godrej Industries, Granules India, HCC, IDBI Bank, IFCI, JP Associates, Just Dial, Kaveri Seed, MRPL, NHPC, Oil India, Reliance Communications, Reliance Naval, Reliance Power, Repco Home Finance, SREI Infrastructure Finance, United Breweries and Wockhardt.

While the move is a watershed one, many feel that the initial impact on the ground may be limited as most traders are squaring off their positions ahead of the settlement date, fearing the incidence of higher securities transaction tax. Currently, if traders exercised their rights, or allowed it to lapse, they have to face STT on the transaction. Fearing this, most traders have squared off their positions.

Delivery mechanism

The NSE is yet to announce the actual mechanism for compulsory delivery. However, if one goes by the rule book of commodity exchanges, which have such compulsory delivery system in place on some contracts, futures positions on gold and silver are allowed to be squared off up to five days before the expiry date. Unclosed positions or fresh positions initiated during the last five trading dates have to be compulsory settled through delivery.

The current experience in the MCX on such contracts suggests that most traders prefer cash-settled contracts, as they square off their current month positions much ahead of the last five days and enter into fresh positions in the ensuing month.

How it will work....

If you don’t square off your positions in the identified stocks before the close of trading hours on the July expiry day, you will either have to take delivery (for long futures, long calls, short puts) or give delivery of the underlying stock (short futures, long puts, short calls) for the contract. Assuming you are long on Adani Power futures, the market lot is 20,000 shares. As the stock is quoting at ₹16.15 currently, you need to have ₹3.23 lakh in your account on expiry day (July 26) to take delivery.

Similarly, the Adani Power 15 call is quoting at a premium of ₹1.85. Though it will cost you just ₹37,000 to buy the option, you will need to shell out ₹3.23 lakh to take delivery of those shares when you are exercising the option. If the premium rises at the time of expiry your burden will be less to that extent.

For a (Put option) of 15 strike, which is quoting at a premium of ₹0.75, you need to have ₹3.23 lakh.

For short futures, long puts and short calls, you need to own 20,000 shares in your account as you are liable to give delivery of shares to the counter-party when he/she exercises his/her right.

Margin burden

With futures and short options, you already have to set aside a 20-30 per cent margin of the overall contract value to take a position. The market regulator had further increased the initial margins for F&O positions from July 2 to reduce the risks to the system and to protect gullible retail investors. Following this, the upfront margin requirements could rise even further, by at least 30-50 per cent.

Those who opt for compulsory delivery have to settle it by July 30.

While traders may tide over the immediate impact of compulsory delivery by squaring off positions early, it needs to be seen if the move will shrink trading volumes in the contracts over time. Stocks could also move into a discount with respect to the spot prices, when they are nearing expiry. So, traders should be wary of new liquidity risks. Else, they could suffer significant margin and capital costs (in auctio of shares) on their derivative trades.

Published on June 29, 2018

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