Mastering Derivatives: Managing long positions to reduce delivery risk

Venkatesh Bangaruswamy | Updated on: Feb 21, 2022

Metallic financial chart and a red arrow on wood surface are showing a drastic decrease. Horizontal composition with selective focus and copy space. | Photo Credit: MicroStockHub

Change in rules and regulations framed by the exchanges and the securities market regulator impacts asset prices. For instance, change in securities transaction tax (STT) at option expiry from STT on settlement price to STT on intrinsic value and the discontinuation of Do Not Exercise (DNE) facility by NSE on close-to-the-money options. This week, we discuss how to adjust your trading strategy to moderate delivery risk arising from the discontinuation of DNE facility.

Cash Vs physical

Delivery risk refers to the risk that you will have to pay to take delivery if you have a long position in an in-the-money (ITM) call or you will have to deliver the underlying if you have a long position in an ITM put at contract expiry.

An advantage of cash-settled system was that even small traders could take long position in options without having to worry about additional capital requirement at expiry. For instance, if you held 1500 strike call and the underlying closed at 1600 at option expiry, you did not have to take delivery of the shares. The difference between the spot price and the strike price (100 points) was cash-settled.

With the discontinuation of the DNE facility, physical settlement means that you are required to take or give delivery of shares if you hold ITM options. That means you must have appropriate funds in your trading account to pay for the shares or have the required number of shares in your demat account to deliver the shares.

Your intention for trading options is to buy calls (puts) and take profits when the underlying moves up (declines). There are two reasons why closing your long options is better than exercising them at expiry. One, you can capture both the intrinsic value and the time value of an option when you close (or sell) long option positions. You can capture only the intrinsic value when you exercise an option. So, closing long position is more profitable than exercising the option. And two, you need significant capital to buy the underlying. The primary objective of trading options is to participate in the underlying movement without taking delivery; for that requires just a fraction of the capital required to buy the underlying.

In the light of the above, it is important to position your option trading strategy such that you are not required to take or give delivery of the underlying. It is preferable to close your position in the week before expiry if you hold options that are close to ITM. Suppose you hold a long position in the 770 strike call on ICICI Bank and the stock trades at 765 a week before expiry, you should consider closing the position. The reason is because the margins on ITM options increase from the previous Friday and peak on the expiry day (Thursday). This way, NSE reduces your risk of default in the event you are required to take or give delivery of the underlying.

Option reading

Note that the adjustment to your trading strategy is required for only equity options and not for index options, which are still cash-settled. This change from cash-settled system to physical settlement on equity options, especially after NSE discontinued with the DNE facility, has left many market participants wondering whether long options are really a “right”.

It is possible that NSE and SEBI may change guidelines as market participants provide continual feedback about the physical settlement process. Meanwhile, it is important that you are mindful of your equity option positions, and not let them become ITM in the week before expiry. In any case, it would be optimal to take profits on long positions when options are close to ITM. This is because European-style settlement makes ITM options less liquid. The physical settlement only gives another reason to close long positions before the options become ITM.

The author offers training programme for individuals to manage their personal investments

Published on February 19, 2022
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