Decoding SEBI’s proposals on future equivalent open interest and market wide position limits

Why is SEBI worried about speculative activity in futures and options segment?

The Securities and Exchange Board of India had conducted two studies on the trading patterns and behaviour of retail investors. The latest study has revealed that 93 per cent of over 1 crore individual F&O traders incurred average losses of around ₹2 lakh in the three years from FY22 to FY24. Top 3.5 per cent of loss-makers, approximately 4 lakh traders, faced an average loss of ₹28 lakh per person over the same period. Only 1 per cent of individual traders managed to earn profits exceeding ₹1 lakh.

These numbers showed that traders were involved in unproductive activity which was resulting in large financial loss. Another worrying factor was that the proportion of young traders, aged less than 30 years, had surged from 31 per cent in FY23 to 43 per cent in FY24.

What are some of the measures taken by SEBI in the last two years to curb speculation in equity F&O segment?

SEBI has been working hard to ringfence retail investors from heavy losses. Last October it came out with a series of measures: It increased the contract value to ₹15 lakh to ₹20 lakh from ₹5 lakh; asking exchanges to discontinue weekly options on several indices and instead have only on one weekly expiry contract on indices. Nifty junked its most famous Bank Nifty while retaining Nifty weekly contracts – BSE retained its weekly contracts on Sensex. It directed exchanges to have expiry of all F&O contracts to a single day; on expiry day it increased the tail risk coverage, an imposed additional Extreme Loss Margin (ELM) of 2 per cent on short index options contracts; and ended margin benefits for calendar spreads on expiry day.

Last month, SEBI came out with a consultation paper. The key proposals included a new methodology for calculating open interest (OI) using a ‘delta’ framework, a review of market-wide position limits (MWPL), and the introduction of position limits for single stocks and index derivatives.

What is “Future Equivalent” (or Delta-based) approach to calculating open interest in option contracts?

Open interest is the number of options or futures contracts that are not closed or settled on a particular day. For instance, the current open interest for Tata Consultancy Services March futures stands around 1.10 lakh – 0.55 lakh short and 0.55 lakh long positions. For every new long position (buy) there should be a counterparty, who is in the short position (sell). Assuming Y initiates a long position and Z takes up the short position, together this long and short positions increase the open interest by one count.

When both the short and the long positions are closed, there is a decrease in open interest. However, there will not be any change in open interest if just one position is closed. For example, Y initiates a long position and Z takes up the short position. After a while, if Y closes the long position and the buyer is X. The new long position of X and the existing short position of Z make one open position, resulting in no change in the open interest.

Currently, OI is calculated by adding open interest of futures and options (in notional terms) for each investor.

A Future Equivalent (FutEq) or Delta-based approach to calculating open interest means that instead of simply adding up the number of outstanding options and futures contracts based on their notional value, it takes into account the price sensitivity of each contract by using their “Delta” values. This approach considers the price sensitivity of each contract. The delta value represents the extent of change in price of the derivative with a change in underlying stock/security.

What will it do to open interest, will it move up or down? Does it help traders?

A FutEq model will reduce the open interests of a stock or index. As mentioned above, this approach will take into account the price sensitivity of each contract by using their “Delta” values – that varies from -1 to 1. Delta will be positive for long stocks, long calls and short puts – generally for bullish bet. It will be in negative for short stock, short calls and long puts (long futures will have a delta of +1 times notional).

Delta will be 1 if the option is in-the-money which means, one rupee movement on the underlying will result in same movement on the option premium as well. If delta is 0.6, then premium will swing 60 per cent or 60 paise for every rupee movement. If it is in minus, the value will decline by that much. The delta will be 0.5 for at-the-money options, that means 50 per cent chance of premium swing with respect to underlying stock price movement. So, the open interest will be reduced by half for at-the-money options.

The net delta values across all positions for a particular underlying for each client, gross aggregated across all clients would constitute the FutEq OI for that scrip/Index.

What are the changes proposed to market wide position limits (MWPL)?

Currently, MWPL for each single stock equals 20 per cent of the stock’s free-float market capitalisation and is applied to the total notional OI of futures and options. This has resulted stock entering ban period frequently, especially in the trending market. Readers may recall that in last August the number of stocks entering the ban period was almost 20. That was over 10 per cent of stocks available in F&O trading. This gave rise to potential manipulation of the stock.

So, SEBI has proposed that the MWPL for single stocks be set as the lower of (15 per cent of free-float market capitalisation) or (60 times the Average Daily Delivery Value, ADDV) in the cash market. This metric will be recalculated every three months based on the rolling ADDV for the preceding three-month period.

A SEBI study (for July 1 to September 30, 2024 period), indicates that under current MWPL rules, there were 366 separate instances of stocks entering the ban period. Under the proposed formulation, these instances drop to 27 — over 90 per cent reduction. This highlights how the new MWPL approach would reduce stocks being pushed into the ban period and make such manipulation more difficult.

The proposed change in open interest calculation and the recalibrated MWPL will benefit traders, as the number of companies entering F&O ban period will be less or even nil.

What are the changes proposed in the computation of exposure limits for mutual funds and AIFs in derivatives?

At present, exposure for futures/short options is currently measured in notional terms, whereas long options exposure is measured solely by premium paid. This does not account for the significant leverage embedded in long options. “Hedged positions in derivatives are not granted any offsetting benefit, and overall exposure is essentially computed on a gross basis without adequate netting of risk,” SEBI observed.

This approach, according to SEBI, may not fully capture the actual risk or leverage in an AIF or Mutual Fund’s derivatives portfolio.

There will be no change in how futures exposure is computed for single stocks and indices, since notional values for long futures already align with their FutEq (Delta = 1 times notional). However, both long and short options will be measured on a FutEq (Delta) basis, capturing their real price sensitivity at a point in time rather than just premium outlay.

For each underlying (stock or index), the net exposure to be the difference between long and short delta values across all instruments (futures, calls, puts, etc.). More complex strategies (e.g. calendar spreads) carry basis and other risks that are not fully captured by Delta alone. SEBI may review such nuances in consultation with stakeholders at a later stage.