In its zeal to reform the Indian stock market, SEBI seems to have gone overboard this time, as it removed the facility of Do Not Exercise (DNE) option from option trading. The new rule not only changes the standard stock market definition of ‘Option’ but also brings small traders and their brokers under systemic risk while it helps larger entities with deep pockets.

The classic definition of an option in share market implies that the option trader has an ‘option’, that is, the trader has the right, but not the obligation, to buy or sell a share at a specific price on or before a certain date. After removing DNE, now it is obligatory for In The Money (ITM) put buyer to either square off his positions i.e., sell his puts before expiry, or buy shares from the auction market and deliver the shares to the put writer.

This alone overturns the sanctity of the concept of option in the Indian stock market once SEBI introduced the new rules abolishing DNE on October 16, 2021.

Its new rule caused havoc in the market for a Hindalco option trade in December expiry as it supported larger and stronger entities who could afford to spend ₹138 crore, or more, while smaller traders were dealt huge liabilities.

Usually, retail traders buy put when they expect a stock to move down. The counter-party acting as put sellers (writers) are big investment banks, brokerage houses and deep-pocket individuals who can put a huge margin before writing the puts. Strangely, regulator Securities and Exchange Board of India (SEBI), as well as stock exchanges NSE and BSE have maintained a stoic silence behind the reasons for repealing the DNE facility. Neither of them responded to Fortune India's detailed questionnaire on the subject.

Implications of new SEBI rule abolishing DNE: The Hindalco case in point

With the increasing number of retail investors and traders flocking the Indian stock market, one would assume that SEBI would have preferred protecting the smaller investors.

Lakhs of retail traders are putting their hard-earned money in the market by banking on the sanctity of the Indian stock exchanges and the regulator. However, the horror story of a Hindalco put option trade that costed lakhs to small retail traders (Read here: New SEBI options rules misfire, share traders bear brunt with lakhs in dues) indicates anti-small-trader actions that are set to hurt the retail populace seeking to earn a living out of the stock market. The action exposes the vulnerabilities of the common man with poorly conceptualised actions of exchanges and regulators.

With the removal of the DNE facility, the small retail trader who used to take limited risk of losing his premium money by buying puts, is now exposed to the unlimited risk of having to buy shares through auction, in case he is unable to square off his positions before expiry.

That is exactly what happened in the Hindalco December expiry, where 450 strike price put buyers could not square off their positions as put sellers (writers) vanished in the last one hour of trade, on the expiry day, i.e. December 30. In absence of buyers, put holders could not square off their positions and were forced to buy shares in auction so that they could provide these shares to put writers at ₹450. That is, they were forced to buy the Hindalco Shares from the open market at a price much higher than ₹450 and sell them at ₹450. EUREKA!

“SEBI, NSE and BSE must explain for whose benefit they are implementing such rules,” asked Anand, an aggrieved trader who lost a big fortune in this trade.

The put holders, who paid a premium of ₹2 per share for a lot size of 1,075 shares of Hindalco, shelled out ₹2,150 per Lot. Since put writers mysteriously vanished on the expiry day, the put holders could not sell their put hold, and thus were unable to square off their positions. They were thus forced to buy the actual shares from the auction market. Which means that if a put holder ‘Held’ one lot of Hindalco, they needed to buy 1,075 shares at price that they got on auction day, which was ₹480 per share. So, a put holder bought one lot of Hindalco by shelling out ₹5,16,000 (1,075 multiplied by ₹480) and then they sold these shares to put writers at ₹4,83,750 (1,075 multiplied by ₹450) suffering a loss of ₹32,250 per lot. On top of that, these retail traders also paid penalty and interest expenses that burned a hole in their pockets.

If the DNE facility was available to these retail traders, the loss would have been limited to ₹2150 per lot, instead of ₹32,250 per lot.

Most retail traders Fortune India contacted were unaware of the abolition of DNE facility. None of the traders were informed by their brokers about the change in the rules. All of them entered that particular trade by assuming that their losses would be limited to the premium they paid to buy the put option.

Since these retail traders are mostly middle-class individuals, they had limited their risks to small amounts that they could afford to lose. However, their losses turned out to be more than 1,500% of their assumed maximum loss. In many cases, where small traders held high lots of put options, they defaulted.

In case retail traders default in droves, their brokers would bear the brunt of these losses. So, if things continue as they are, such defaults may create systemic risks in future. This rule also jeopardises brokers who have a high number of retail traders like Zerodha, Upstox, Groww, and 5Paisa.

Institutions evading response to the plight of the common man

Trading rules are meant to stabilise the system. They are also designed to ensure they protect the smallest trader, rather than the biggest. However, stock market regulator SEBI and stock exchanges made it obligatory for option Traders to either square off trades or deliver shares after expiry day, hurting them the most. Fortune India sent detailed questionnaires to NSE, BSE and SEBI to understand the rationale behind abolishing the facility of Do Not Exercise (DNE) option. The three institutions chose not to respond.

NSE denied having received any e-mail, despite the fact the mail was sent twice. When the same questionnaire was sent to the same NSE personnel through WhatsApp, Fortune India was asked to direct queries to the exchange’s PR agency. The NSE personnel told Fortune India that one of the authorised respondents of NSE is on sick leave and the other is vacationing in the U.S.

Fortune India is still awaiting responses on its questionnaire from SEBI and BSE.

Dinesh M, one of the victims of the new SEBI rule, had contacted his broker, ICICI Direct, multiple times, directly. On receiving no explanation from them about his frozen demat account and money deducted from his account, he reached out to ICICI Direct through social media too. However, till January 12, he has not received the contract note from ICICI Direct regarding his Hindalco put option trade of December 30 expiry.

Fortune India received a response from ICICI Direct where they declined to comment on Dinesh's case stating that, "Under regulatory requirements, we are constrained from sharing any customer specific information with third party entities."

Anand Solanki, one of the sub-brokers of Profitmart, also a victim of the new SEBI rule, was threatened by his broker to pay around ₹42 lakh for the Hindalco put option trade. Profitmart has neither acknowledged nor responded to Fortune India questionnaire.

Silence exercised by the exchanges, regulator SEBI and brokers on this issue is a matter of concern for traders whose losses have gone beyond their capability to absorb.

“Every rule is made to protect a small guy on the street but here the rules are contrary to the interest of retail and neither brokers nor exchanges are letting us know for whose benefit DNE facility was removed,” says an aggrieved trader who lost a big fortune on this trade.

Anand Solanki, called on NSE Support landline many times, where he only got assurances sans any solution.

Who benefits from the removal of DNE facility?

While scores of small retail traders are losing lakhs in a trade, in the stock market another lot is surely profiting from those losses.

On the expiry day, over 32 lakh shares were in option queue and remained unsettled. Taking delivery of these 32 lakh shares needs a capital of approximately ₹138 crore (32 lakh x ₹450).

For sure, there were some option writers who were ready to take delivery of shares at Rs 450. These players seem to have deep pockets as they voluntarily vanished from the market on expiry day, thus showing their interest in taking physical delivery of shares.

Also, all option writers conveniently vanishing en masse, one hour before closing hints at a synchronised move by a cartel rather than a coincidence. And since the option writers vanished en masse on expiry day, leaving 32 lakh unsettled shares in option queue, they would know that their counter parties (put holders) would come in droves to buy shares in auction.

Assuming that the disappearance of the Option Writers was a synchronised move, it would be expected that they would know that the move would create a huge demand for actual shares before auction. Thus, anyone with the fore-knowledge of the vanishing trick to be played by the option writers would have cornered a huge chunk of Hindalco Shares, provided they had deep pockets.

The entire episode of Hindalco put option trade of December expiry reeks of exploitation of the new rules, by some entities who banded together to rig the game in their favour.

This is not the first time that the small fish got preyed upon by bigger fishes in the murky waters of the Indian capital markets. And for sure, the hunting games will continue with such unfavourable rules.

(Update: The story has been updated with ICICI Direct's response in the 20th para.)

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