From THE HINDU group of publications
Sunday, July 15, 2001


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Other restrictive criteria

B. Venkatesh

Anup Menon

SEBI has also selected stocks for options trading on the liquidity criterion. Stocks that are relatively more liquid have been chosen for `options' trading.

Our argument is that options trading should also be introduced in stocks that are not liquid. Also, SEBI's condition on a minimum size of non-promoter holding appears needlessly restrictive.

Illiquid stocks

Why has SEBI introduced options on only liquid stocks? The capital market regulator fears that illiquid stocks may be subject to price manipulations. Take Sundram Fasteners, a thinly traded stock. What will happen if options trading is allowed in it? Suppose a trader buys 10 contracts of 200 August call options on Sundram Fasteners at, say, Rs 10 per option. This means the trader has the right to buy 16,000 shares (10 contracts multiplied by 2 lakhs divided by the spot price of, say, Rs 125) of Sundram Fasteners at any time before end August at Rs 200 per share.

Sometime in July, suppose Sundram Fasteners is trading at Rs 150 and the option buyer wants to profit from his position. He can manipulate the stock price in the spot market to profit from his call positions. How? Because Sundram Fasteners is thinly traded, he can engineer deals that will push up the stock price in the spot market.

If the stock price rises to, say, Rs 250 in the spot market, the call buyer can profit in two ways. He can exercise his call options, sell the shares in the spot market and pocket Rs 50 (Rs 250-200) times 16,000 shares. Or he can sell the call option at a higher price and take profits; the call option will trade at a higher price because Sundram Fasteners' spot price has risen to Rs 250 whereas the strike price of the option is only Rs 200. In other words, the option price will rise as the call is now in-the-money.

An option buyer can, thus, manipulate the prices in the spot market to convert an out-of-the-money or at-the-money option into an in-the-money option. The put buyer of illiquid stocks can adopt a similar strategy. But is price manipulation a valid reason for not introducing options on such stocks? We think not. Here is our argument.

Options are primarily a bet on volatility. And since illiquid stocks are volatile, options should be introduced in such stocks as well. This may temper liquidity of such stocks in the spot market. How?

Since buying the stock is costlier, traders wanting to bet on the stock price movements may be more inclined to buy options. This strategy may significantly shift speculative trades from the spot to the options market. Of course, shifting trades to the options market does not prevent price manipulation in the spot market. But we believe that two safety nets can take care of that problem.

The first safety net is that option contracts should not be cash-settled, as SEBI has directed, but settlement should be by delivery of the underlying shares. Why? Cash-settling options means writers can sell as many contracts without having to deliver the underlying shares in the event of the option buyer exercising his/her right. As more option contracts are sold, the associated risk increases. This may prompt the option buyers/sellers to engineer prices in the spot market to protect their positions.

Settlement of option contracts by delivery of the underlying is, therefore, preferable. To further temper price manipulation in the spot market, our suggestion is that the outstanding option contracts on illiquid stocks should not be more than their respective average trading volumes in the previous year. Why the preference for average trading volumes over free float?

Consider Sundram Fasteners. Suppose the stock's free-float is one lakh shares, of which only 10,000 shares are traded on an average everyday. What will happen if option writers sell contracts whose underlying represents 50,000 contracts and all of them are exercised? The option writers cannot deliver the underlying Sundram Fasteners' shares to the option buyers.

The reason is that only 10,000 shares are traded in the market whereas 50,000 shares are needed for delivery. This will cause option writers to scramble to the spot market to acquire Sundram Fasteners shares. Such a situation presents speculators an opportunity to push up prices in the spot market to their advantage.

Now, such a situation can be avoided if options are written only to the extent of the average daily volume in the respective stocks. This rule calls for two definitions: SEBI has to define illiquid stocks as well as the computation of the average daily volumes.

The second safety net is the rolling settlement cycle, which will act as a protection against indefinite price manipulation in the spot market. How? Price manipulation typically requires maintaining open position for several days, which is not possible under the rolling settlement cycle. While a shrewd trader can continually manipulate prices intra-day to short-squeeze option writers, such manipulation may not snowball into a big problem.

In the light of the above factors, option trading can be introduced in illiquid stocks. This means we need to re-assess SEBI's rule on non-promoter holding, which is also based on the ill effects of illiquidity.

Non-promoter holdings

SEBI has stated that stocks of companies with non-promoter holding of less than 30 per cent are not eligible for options trading. SEBI's rationale is based on a possible price manipulation in the spot market due to the stock's illiquidity.

It, however, appears that the benefits of allowing options trading may overwhelm the disadvantages. Our argument rests on the belief that enabling investors to take positions in stocks that are otherwise illiquid may actually temper their volatility in the spot market.

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Consider Wipro, a company with a non-promoter holding that is considerably less than the SEBI stipulated minimum of 30 per cent. The stock displayed an average daily volatility of 5.77 per cent during the same period. Other stocks such as Mascon Global and Engineer's India are so illiquid that investors find it difficult to sell their holdings in the market even if they were able to buy these stocks in the first place.

Option trading on such stocks, however, enables investors to take positions without risking high downside due to volatile price movements in the spot market. This could have positive primary effects. If more investors take positions in options, the price discovery process of that stock in the spot market will improve.

Consider Engineer's India, which is currently trading at close to Rs 100. Investors are apprehensive of buying the stock due to its low free float. The lack of buying interest, in turn, may hamper price discovery in the stock. Engineer's India could be, perhaps, worth Rs 125 if more investors were to buy the stock.

Now, allowing options trading in such stocks could enable a price discovery process in the spot market as the option premium will reflect the market's view in the stock concerned. How? Suppose the option premium on Mascon Global rises from Rs 10 to Rs 15 per option, investors may discern that the price rise following heavy demand is due to the options being attractive at the price strike, say, Rs 150. This may prompt buyers in the spot market to gradually adjust the stock price to its strike price under the options contract.

There may, however, be problems if all buyers of options on an illiquid stock prefer to exercise their rights. How will the option writer deliver the underlying? Our suggestion is that SEBI should have a two-tier definition for illiquid stocks. Tier I illiquid stocks will attract options trading subject to their respective daily average trading volumes, provided the average volumes are higher than a specified limit. Stocks such as Nestle and Colgate may attract this rule.

Tier II illiquid stocks will attract options trading which need to be necessarily cash settled, with free float as a cap. Stocks such as Mascon Global and Wipro will fall in Tier II. Suppose Mascon Global has a free float of 50,000 shares, option contracts on the stock can be traded such that the underlying represents not more than 50,000 shares. The settlement, however, will be on a cash basis.

Our suggestion for cash settlement is that delivering the underlying shares based on the average trading volumes may restrict option trading in such stocks. At the same time, an option-trading rule of delivering the underlying shares based on free float gives room for price manipulation in the spot market.

Summing up, we believe SEBI can introduce options in stocks that are illiquid. Such a measure may temper volatility in the spot market, provided SEBI builds in adequate safeguards on writing options. Our suggestion is that option contracts ought to be based on a two-tier rule.

Options on Tier I illiquid stocks can be contracted to the extent of the average daily volumes in the previous year. Options on the Tier II illiquid stocks, on the other hand, can be cash-settled with free float as a cap. Then, there is the rolling settlement system, which will temper price manipulations in the spot market. Further modifications to the trading rules can be looked at after the options market stabilises.

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