In a major relief to stock traders, the National Stock Exchange of India (NSE) has reintroduced the ‘Do not Exercise’ facility on expiry day in the stock option contracts, effective April 28, 2022. With the reintroduction of this DNE instruction, a stock market investor can now minimise his/her loss and eliminate the risk of a physical delivery to a certain extent. In October 2019, Sebi mandated the physical settlement of stock derivatives. That is, if your position in any stock option contract is open on the expiry day, you will be required to take/give delivery of stocks when the option is exercised. The contract gets exercised only if it is ITM (In-The-Money) at the time of expiry.
A new circular dated April 11 by NSE Clearing Ltd, a part of NSE, said, “It may be noted that facility to specify ‘Do Not Exercise’ instruction on expiry day will be re-introduced in Stock Option contracts with effect from April 28, 2022.”
What is DNE?
The system, which was introduced in 2017, was a fail-safe for options traders during the time of cash-settlement of options contracts. Manoj Dalmia, Founder and Director- Proficient Equities Limited, said: “It is a fail-safe for options traders during the time of cash-settlement of options contracts. As per notice from SEBI if the spot price of a share closes below the strike price, then the trader holding the Put option of stock will have to either sell his position before expiry or arrange shares from the auction.”
What Happens Currently?
Under the current system, it was mandatory for traders to either square off their existing in-the-money positions before the expiry of the contract or ensure physical delivery. The situation for a put option buyer holding in-the-money contracts at the time of the expiry was especially grim as he would have to buy the shares from the auction and deliver to the put writer.
In 2019, the Securities and Exchange Board of India (Sebi) mandated that all options contracts be physically settled.
DNE was first introduced in 2017 when the Securities Transaction Tax (STT) used to be charged for the entire contract value, unlike today, where it is charged for the option premium value. By using a DNE instruction, clients could tell their brokers not to exercise the option strike price if the STT amount was greater than the premium value of the respective option contract. But it was discontinued in October 2021 as the STT tax law changed.
The removal of DNE in October 2021 created a risk of physical delivery. For instance, if a client did not settle his option contract before expiry, he would need to take or give delivery of the respective stock mandatorily, irrespective of whether or not he had sufficient funds in his account.
In January, the risk became real after several traders complained of humungous losses in the out-of-money put options of Hindalco Industries expiring in December, which suddenly became in-the-money on the day of the expiry due to a sudden fall in the share price in the closing hours of the session.
The catastrophic losses suffered by many retail investors who had bought Hindalco’s out-of-money put options was largely a function of lack of awareness of the new rules that were introduced in October 2021.
Earlier this year, market participants such as Zerodha’s Co-founder Nithin Kamath highlighted that the removal of the ‘Do not exercise’ option has created risk of huge losses for traders whose positions in the out-of-money options suddenly became in-the-money at the time of the expiry.
How Will Reintroduction of ‘Do Not Exercise’ Options Help Traders
With the reintroduction of the ‘do not exercise’ options, traders will now be able to give explicit instruction to brokers to not exercise the option and automatically square off their out-of-money positions.
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