DNE: All About Do Not Exercise by NSE
The National Stock Exchange (NSE) is bringing back the ’do not exercise’ (DNE) instruction in stock options from April 28, 2022. The stock exchange discontinued the practice in October 2021. It was introduced in 2017.
The DNE instruction acts as a fail-safe for options traders at the time of cash settlement of the options contracts.
This was after SEBI’s Risk Management and Review Committee recommended bringing back DNE to safeguard the interests of the options traders. However, it must be noted that DNE will only be allowed for up to 3 strike prices of the stock option.
After the introduction of the physical delivery settlement, the DNE system became redundant since the risk of paying an STT (securities transaction tax) was not present.
With the DNE system coming back, risks and losses in the expiry of options contracts will be mitigated where traders and brokers are unable to meet their settlement obligation in situations involving physical delivery.
What is DNE?
The DNE is an instruction that brings relief to the traders and brokers. That is, DNE allows them to not exercise an option. Allowing a profit-making options position to expire may lead to significant losses for traders and brokers.
Just like futures, options are also settled with shares upon expiration of the contract. However, there were several instances recently where traders and brokers were not able to honour this commitment and exit the options contract before the expiration on the last Thursday of a month.
The DNE system aims to prevent this risk around the physical settlement of trades.
Why is DNE being brought back?
Why is DNE being brought back?
In the December 2021 expiry contract, there was one incident where Hindalco’s shares became risky for brokers and traders who were not able to sell and square off their Hindalco Put options due to DNE being unavailable. They suffered significant losses. This is because, if you as a trader don’t square off your position on the date of expiry, the options contract will be physically settled.
Ideally in a put option, traders expect the stock price to go down from the Spot price while in a call option, the traders expect the price to go up. Traditionally, the trader’s losses were limited to the premium they paid on a contract, safeguarded by the DNE system. However, after SEBI revoked the DNE system, an options buyer faces unlimited risk if they are not able to settle their trades.
This is what happened in the Hindalco episode.
There were traders who were holding a 450 strike price put option for Hindalco who were not able to settle their trade due to a sudden disappearance of options buyers. Consequently, they were not able to square off their trades for a difference of as little as 35 paise.
On December 30, 2021, the Hindalco spot price closed at Rs 449.65. On the same day, Hindalco was trading in the range of Rs 451-453; but suddenly, the price went down to Rs 448 after 2:30 PM. The unavailability of put option buyers at the same time pushed the traders holding 450 strike price into a lull. Many were not able to square their positions.
The larger brunt of this incident was felt by smaller traders.
Put options holders who paid a premium of Rs 2 per share for a lot of 1,075 shares paid Rs 2,150 in premiums. With put buyers vanishing, the put holders were forced to buy 1,075 at the market price at Rs 480 per share, paying Rs 5,16,000. Part from paying penalty and interest, the put holders then sold the shares to buyers at a loss of Rs 32,250 per lot.
For a difference of mere 35 paise, there are many brokers and traders who ran into losses as high as Rs 35 lakh. If the DNE system was in place, these smaller traders would have faced a loss of only the premium amount, which is Rs 2,150 per lot, and not Rs 32,250 per lot.
In the DNE-era, traders were exposed to the maximum risk of only losing their premium money. With the non-availability of DNE, traders were forced to buy the shares in auction in order to settle the trade. It exposed the traders to systemic risk while helping larger entities with deep pockets.
There were also other incidents where brokers and traders failed to deliver the promised shares to settle their trade and ran into trouble. Essentially, they lacked the requisite number of shares in their demat account or the money to fulfill their obligation.
The Hindalco episode was one of the precursors for SEBI’s Risk Management and Review Committee to consider re-introducing DNE as the traders were facing huge risks.
Until 2019, stock futures and options in India’s stock exchanges were settled in cash after which, compulsory physical delivery on the expiration date was introduced. The DNE facility will prevent the risks around the physical settlement, allowing brokers to stop exercising options on behalf of their clients.
The re-introduction of the DNE allows brokers and traders the option to not exercise their option and prevents them from forcibly settling the trade.
The takeaway
Brokers and traders had been demanding re-introducing the DNE instruction, especially in the Close to the Money (CTM) options contracts. The re-introduction of the DNE system will prevent traders and brokers from facing insurmountable losses in case they are not able to settle the trade.
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