30th December 2021 - The Hindalco case
It all started with a SOS tweets from Shri Dixxxx M and Shri Anxxx asking for help from fellow traders on twitter. Here are the snapshots.
What exactly had happened?
The traders like Dixxxx and Anxxx had bought Hindalco 450 PE option in December series. It was the expiry day. Throughout the day Hindalco was trading above 450. Here is the screenshot.
Hindalco on 30th December 2021
Since Hindalco was trading above 450 the 450PE would have expired worthless and option buyers would have lost their entire premium. However at 3:00 PM, the stock price went below 450 to about 448, that means now the 450PE will have some intrinsic value. But when these traders went to sell their put option, to their surprise, there were no option buyers. Here is a snapshot of market depth.
Image source : Zerodha
On closing bases last traded price of Hindalco was 451.95, however closing price (that is weighted average of last half an hour) was 449.65. That means the 450PE is now in the money. Here is the snapshot from NSE website.
Before understanding what happens next, let us go through the SEBI rules and regulations.
In October 2019 SEBI introduced compulsory physical delivery on expiry. That means if a trader is holding future or option that expires in the money than the trader is required to give or take physical delivery of the underlying stocks. Check the circular here.
However an option buyer had an option whether to exercise the option or not. If a option buyer wishes not to exercise the option than he could use Do Not Exercise (DNE) facility. In this case no give or take of shares will happen. An option buyer had the right but not the obligation to buy or sell the shares.
On September 29, 2021, SEBI published a circular discontinuing Do Not Exercise (DNE) facility from October 14, 2021.
Here SEBI made it mandatory for option buyer to take delivery. If he is a call option buyer and give delivery if he is a put option buyer.
Now let us come back to Hindalco case.
Since there was no Do Not Exercise (DNE) facility available and Hindalco 450 PE become ITM on expiry, the option buyer has to compulsory give delivery of stocks. If trader has stocks in his account than they will be auto debited and delivered to the seller. But what if a trader does not have stocks with him?
This is what had happened to many traders on 30th December 2021. Unaware of the latest SEBI circular, few option traders bought huge quantity of Hindalco 450 PE thinking that they have the option of Do Not Exercise (DNE) facility if put expires in the money. To their surprise neither option buyers nor DNE facility was available. These traders were trapped and they were forced to give delivery. Since the quantity was huge, they were in no position to buy the stocks and give delivery. This resulted in short delivery.
Consequences of short delivery
If shares are not delivered on T+1 day, exchange blocks margin called valuation debit from brokers account and conducts auction on T+2 day. Exchange buys shares from auction market and delivers them to the buyer and auction penalty note is sent to defaulting broker, who further passes on the penalty to the client. Auction penalty could be as high as 20% of the contract value.
Apart from auction penalty, defaulting client will have to pay mark to market difference if any. Since auction happens on T+2 day, the share price could go up and shares bought in auction market may be priced much higher than the sell price. This mark to market difference multiplied by the huge quantity will result in massive loss to the seller.
In addition to this if trader don't have required money in his account than there will be debit balance. Debit balance will attract interest at the rate of 0.05% per day
On top of this broker will charge brokerage in terms of percentage of contract value that is about 0.25% of contract value.
If this is not enough next comes Securities Transection Tax (STT) which is 0.1% of contract value and other charges.
All this charges are clubbed and sent to client and client has to pay them to broker.
Same thing happened in case of Hindalco 450 PE buyers. Traders who had bought options for few thousand rupees had to face massive loss in lakhs of rupees. Option buying was thought to be having limited risk but due to SEBI's new rules even option buying can have unlimited risk.
Now the next big question, what if client refuses or is not in a position to pay the amount?
In such case, the matter is placed before arbitration court and court gives further decision on the matter.
What is the solutions?
- Avoid expiry day risk - If trader has no intension to take or give delivery of stock than square off the positions before expiry day and avoid taking any new positions on expiry day.
- Expiry day trade - Trade expiry day only if trader desires to take or give delivery. In this case trader should have cash to take delivery or stock to give delivery.
- Take counter position - If at all trader wants to trade expiry day and do not wish to take or give delivery and for some or the other reason if a trader is not able to square off the position (as in Hindalco case where there was no liquidity) than the last resort is to take a counter position in futures. This will net off the trader's give and take obligation. However to avoid the risk of short delivery most of the brokers will not allow fresh buy stocks position on expiry day. In this case a trader will have to call his broker, explain the situation and let him allow you take the counter position to avoid short delivery.
- Reinstate Do Not Exercise (DNE) facility - SEBI should reconsider its decision to abolish DNE facility and reinstate Do Not Exercise as similar setup is available in all other major exchanges world wide.
lastly, was the Hindalco case the operators game?
It could be very well be the operators game.
A cartel with lots of cash deliberately vanish on the expiry day forcing the retail traders to give delivery. Since there is a window of T+2 days for settlement, the cartel can manipulate the stock price and take the price higher to their benefit. Similar thing was observed in Hindalco case.
What do you think? Put your thought in comment below.
Happy Trading.
Disclaimer:- The article is for educational purpose only. Please consult your financial advisor before making any investment decision.
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