Risk containment measures and the broad eligibility criteria of stocks on which stock options and single stock futures could be introduced - SEBI - SMDRP/DC/CIR-13/02

Circulars CHIEF GENERAL MANAGER DERIVATIVE CELL SMDRP/DC/CIR-13/02 December 18, 2002 To, The Chief Executive Officer/ Managing Director of Derivative Segment of NSE BSE and their Clearing House / Corporation. Dear Sir, Sub: Risk containment measures and the broad eligibility criteria of stocks on which stock options and single stock futures could be introduced. This is in continuation of SEBI Circular No. IES/DC/CIR-4/99 dated July 28, 1999, Circular No. IES/DC/CIR-5/00 dated December 11, 2000, Circular No. SMD/DC/Cir-7/01 dated June 20, 2001 and SEBI Circular No. SMD/DC/Cir-10/01 dated November 2, 2001 for Exchange traded Index Futures, Index Option, and Stock Option Contracts, and Stock Futures Contract. The aforesaid circulars were addressed to SEBI approved Derivative Exchange / Segment and their Clearing House / Corporation (hereinafter collectively referred to as Exchange). SEBI had setup an Advisory Committee on Derivatives headed by Prof. J. R Varma to inter alia review the eligibility criteria of stocks on which stock options and single stock futures could be introduced. The Advisory Committee gave its recommendation in its report on Development and Regulation of Derivative Markets in India . The report of the Advisory Committee was placed on the SEBI website for public comments. The SEBI Board in its meeting on November 29, 2002 considered the recommendations made in the report and also considered the comments received from the public. Based on the recommendation of the Advisory Committee on Derivatives, the eligibility criteria for stocks on which stock option and stock futures could be introduced and the modifications in the risk containment measures are specified hereunder. Eligibility Criteria of Stocks - Clause 7 of Circular No. SMD/DC/Cir-7/01 dated June 20, 2001 and Clause 6 of Circular No. SMD/DC/Cir-10/01 dated November 2, 2001 on eligibility criteria of stocks on which stock option and stock futures could be introduced, stand modified in the following manner by this present circular. A stock on which stock option and single stock future is proposed to be introduced shall conform with the following broad eligibility criteria:- The stock shall be chosen from amongst the top 500 stock in terms of average daily market capitalisation and average daily traded value in the previous six month on a rolling basis. The stock s median quarter-sigma order size over the last six months shall be atleast ₹ 5 Lakh. For this purpose, a stock s quarter-sigma order size shall mean the order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation. The Exchange shall be guided by the following for the purpose of calculating quarter sigma order size in a stock:- Quarter sigma order size shall be calculated by taking four snapshots in a day from the order book of the stock in the past six months. These four snapshots shall be randomly chosen from within four fixed ten-minutes windows spread through the day. The sigma (standard deviation) or volatility estimate shall be the daily closing volatility estimate which is also used for day end initial margin calculation in derivative contracts on a stock. For stocks on which derivative contracts are not traded, the daily closing volatility estimate shall be computed in the manner specified by Prof. J.R Varma Committee on risk containment measures for Index Futures. The daily closing volatility estimate value shall be applied to the day s order book snapshots to compute quarter sigma order size. The quarter sigma percentage shall be applied to the average of the best bid and offer price in the order book snapshot to compute the order size to move price of the stock by quarter sigma. The median order size to cause quarter sigma price movement shall be determined separately for the buy side and the sell side. The average of the median order size for the buy and the sell side shall be taken as the median quarter sigma order size. The Exchanges (at present, The Stock Exchange, Mumbai (BSE) and The National Stock Exchange of India Ltd (NSE)) shall work together and use a common methodology for carrying out the calculations. The details of calculation methodology and relevant data shall be made available to the public at large on the website of the exchange. The quarter sigma order size in a stock shall be calculated on the 15th of each month, on a rolling basis, considering the order book snapshots in the previous six months. Similarly, the average daily market capitalisation and the average daily traded value shall also be computed on the 15th of each month, on a rolling basis, to arrive at the list of top 500 stocks. The number of eligible stocks may vary from month to month depending upon the changes in quarter sigma order sizes, average daily market capitalisation average daily traded value calculated every month on a rolling basis for the past six month. Consequently, the procedure for introducing and dropping stock on which option and future contracts are traded shall be as follows:- Options and futures may be introduced on new stocks when they meet the eligibility criteria. If a stock fails to meet the aforesaid eligibility criteria for three months consecutively, then no fresh month contract shall be issued on that stock. However, the existing unexpired contracts may be permitted to trade till expiry and new strikes may also be introduced in the existing contract months. The Exchange may compulsorily close out all derivative contract positions in a particular underlying when that underlying has ceased to satisfy the eligibility criteria or the exchange is of the view that the continuance of derivative contracts on such underlying is detrimental to the interest of the market keeping in view the market integrity and safety. The decision of such forced closure of derivative contracts shall be taken in consultation with other exchanges where such derivative contracts are also traded and shall be applied uniformly across all exchanges. For unlisted companies coming out with initial public offering, if the net public offer is ₹ 500 Crore or more, then the exchanges may consider introducing stock options and stock futures on such stocks at the time of its listing in the cash market. Derivative contracts on a new stock index shall be permitted if the stocks contributing 90% weightage in the index are individually eligible for derivative trading as per the eligibility criteria. This requirement shall be applied only at the time of introduction of derivative contract on new indices. The Exchanges may submit their proposal to SEBI for approval. Risk Containment measures In light of the broad eligibility criteria, the following changes may be incorporated in the risk containment measures prescribed by SEBI from time to time:- Price Scan Range four snapshots shall be randomly chosen from within four fixed ten-minutes windows spread through the day. Clause 6(A) of Circular No. SMD/DC/Cir-7/01 dated June 20, 2001 and clause 7(A) of Circular No. SMD/DC/Cir-10/01 dated November 2, 2001 stand modified, in the following manner, by this present circular. For the purpose of computing worst scenario loss on a portfolio, the price scan range for stock option and single stock future contracts shall henceforth be linked to liquidity, measured in terms of impact cost for an order size of ₹ 5 Lakh, calculated on the basis of order book snapshots in the previous six months. Accordingly, if the mean value of impact cost exceeds 1%, the price scanning range would be scaled up by square root of three. This would be in addition to the requirement of scaling up for the look-ahead period i.e. the time in which mark to market margin is collected. The guidance for computation of impact cost for an order size of ₹ 5 Lakhs is as under:- Impact cost shall be calculated by taking four snapshots in a day from the order book in the past six months. These four snapshots shall be randomly chosen from within four fixed ten-minutes windows spread through the day. The impact cost shall be the percentage price movement caused by an order size of ₹ 5 Lakh from the average of the best bid and offer price in the order book snapshot. The impact cost shall be calculated for both, the buy and the sell side in each order book snapshot. The mean of the impact cost for both the buy and the sell side in each order book snapshot in the past six months shall be computed to determine the applicable price scan range in the stock. The Exchanges (at present, BSE NSE) shall work together and use a common methodology for carrying out the calculations. The details of calculation methodology and relevant data shall be made available to the public at large through the website of the Exchanges. The mean impact cost shall be calculated at 15th of each month on a rolling basis considering the order book snapshots of the previous six months. If the mean impact cost or a stock moves from less than or equal to 1% to more than 1%, the price scan range in such stock should be scaled up by square root of three and the scaling should be dropped when the impact cost drops to 1% or less. Such changes will be applicable on all existing open position within three days from the 15th of each month Exposure Limits Clause 6(G) of Circular No. SMD/DC/Cir-7/01 dated June 20, 2001 and clause 7(C) of Circular No. SMD/DC/Cir-10/01 dated November 2, 2001 stand modified, in the following manner, by this present circular. The exchange shall ensure that the higher of 5% or 1.5 (standard deviation) of the notional value of gross open position in single stock futures and gross short open position in stock option in a particular underlying is collected/adjusted from the liquid networth of a member on a real time basis. For the purpose of computing 1.5 standard deviations, the standard deviation of daily logarithmic returns of prices in the underlying stock in the cash market in the last six months shall be computed. This value shall be applicable for a month and shall be re-calculated at the end of the month by once again taking the price data on a rolling basis for the past six months. Position Limits The existing client level position limits and market wide position limits specified in the SEBI Circular No. SMD/DC/Cir-10/01 dated November 2, 2001 shall continue. The trading member position limits shall however be linked to market wide limit. For stocks, in which the market wide position limit is less than or equal to ₹ 250 Crore, the trading member limit in such stocks shall be 20% of the market wide limit. For stocks, in which the market wide position limit is greater that ₹ 250 Crore, the trading member position limit in such stocks shall be ₹ 50 Crore. The aforesaid changes in the risk containment measures shall be implemented before the list of eligible stocks is expanded or January 01, 2003, whichever is earlier. The Exchanges shall endeavor to institute the risk containment measures by January 1, 2003. The Derivative Exchange/Segment may select eligible stocks for introduction of stock option and single stock future contracts, applying the broad eligibility criteria specified in this circular, and submit their proposal to SEBI for approval of the contract/s. Yours sincerely, N. PARAKH