Chapter 9: Regulatory Framework for Financial Derivatives in India (Part 2)

9.3.4 Position Limits for Derivatives Trading

Overview of Position Limit Architecture

To prevent market manipulation, excessive speculation, and concentration of risk, position limits are mandated by SEBI across four distinct tiers: Trading Members (TMs), Clients, Market-Wide Position Limits (MWPL), and Foreign Institutional Investors (FIIs) / Mutual Funds (MFs).

1. Trading Member (TM) Level Position Limits

Trading member position limits vary depending on whether the instrument is an index derivative or a stock derivative:

• Equity Index Option Contracts: The position limit is the higher of Rs. 500 crore or 15% of total open interest in the market in equity index option contracts across all option series on a specific underlying index.
• Equity Index Futures Contracts: The position limit is the higher of Rs. 500 crore or 15% of total open interest in the market in equity index futures contracts across all futures series on a specific underlying index.
• Stock Futures and Options Contracts:
  • Stocks with MWPL >= Rs. 500 crore: Combined F&O position limit is 20% of applicable MWPL or Rs. 300 crore (whichever is lower). Within this limit, the stock futures position cannot exceed 10% of applicable MWPL or Rs. 150 crore (whichever is lower).
  • Stocks with MWPL < Rs. 500 crore: Combined F&O position limit is 20% of applicable MWPL. The stock futures position alone cannot exceed 20% of applicable MWPL or Rs. 50 crore (whichever is lower).
  • Note: The Clearing Corporation specifies these TM-wise position limits on the last trading day of the month for execution during the subsequent month.

2. Client Level Position Limits

For individual clients, the gross open position across all derivative contracts (futures and options) on an underlying stock must not exceed the higher of:

• 1% of free float market capitalization (measured in terms of number of shares), OR
• 5% of open interest in all derivative contracts in the same underlying stock (measured in terms of number of shares).

3. Market Wide Position Limits (MWPL)

Market Wide Position Limit establishes the ceiling on total open positions across all market participants for a specific stock derivative.

• MWPL Quantum: Set at 20% of the non-promoter holding (free float) in terms of number of shares of the underlying company.

MWPL Monitoring and Ban Enforcement Mechanism

1. EOD Threshold Breach (95% Trigger): At the end of each trading day, the exchange checks if total market-wide open interest in a scrip exceeds 95% of its MWPL. If breached, the exchange issues a ban notice; from the next trading day, participants can trade in that scrip only to reduce existing positions through offsetting trades.
2. Penalties for Violation During Ban: If a member or client increases an existing position or creates fresh positions while the ban is active, a penalty based on a specified percentage/basis points of the increase in notional value is levied and collected before trading opens the next day.
3. Resumption of Normal Trading: Normal trading in the scrip resumes only after the total open position falls to 80% or below of the MWPL.
4. Phasing Out / De-listing Scrips: If a stock remains subject to a trading ban for a significant part of the month consistently for three consecutive months, the exchange phases out derivative contracts on that underlying stock.

4. FII and Mutual Fund (MF) Position Limits

Mutual funds participate in derivatives at par with Foreign Institutional Investors (FIIs). MF schemes are treated as clients/sub-accounts, while MFs as entities are treated like registered FIIs.

• Index Options: Higher of Rs. 500 crore or 15% of total market open interest in index options per exchange.
• Index Futures: Higher of Rs. 500 crore or 15% of total market open interest in index futures per exchange.
• Hedging / Portfolio Exposure Limits:
  • Short Positions: Short positions in index derivatives (short futures, short calls, long puts) must not exceed the notional value of actual stock holdings.
  • Long Positions: Long positions in index derivatives (long futures, long calls, short puts) must not exceed the notional value of holdings in cash, Government Securities, T-bills, and similar liquid instruments.
  • Excess Position Treatment: Any surplus beyond these cash/stock holdings is deemed to comprise short and long positions in equal proportion to total open positions and is monitored against asset holdings reported daily by custodians.
• Stock Derivative Limits for FIIs/MFs:
  • MWPL >= Rs. 500 crore: Combined F&O limit is 20% of MWPL or Rs. 300 crore (whichever is lower); stock futures limit <= 10% of MWPL or Rs. 150 crore (whichever is lower).
  • MWPL < Rs. 500 crore: Combined F&O limit is 20% of MWPL; stock futures limit <= 20% of MWPL or Rs. 50 crore (whichever is lower).
• Sub-Account / MF Scheme Level Limits:
  • Index F&O Disclosure: Any person or group acting in concert owning 15% or more of total open interest in index derivatives must disclose the holding to the clearing corporation.
  • Single Stock F&O Limit: Gross open position across all derivative contracts on a single stock cannot exceed the higher of 1% of free float market cap (number of shares) OR 5% of open interest in derivative contracts on that underlying stock.

9.3.5 Reporting of Client Margin

Clearing Members (CMs) and Trading Members (TMs) are bound by mandatory margin reporting regulations to ensure capital adequacy and transparent risk tracking:

• Mandatory Upfront Collection: CMs and TMs must compulsorily collect upfront initial margins from all trading members and constituents clearing through them.
• Daily Reporting by CMs: Clearing members must report daily to NSCCL full details of initial margins due and collected from TMs/clients for trades executed and open positions maintained.
• Daily Reporting by TMs: Trading members must report daily details of margins collected from clients and deposited with CMs.

9.4 Adjustments for Corporate Actions

Corporate actions in underlying cash market equities—such as bonus issues, stock splits, rights issues, and dividends—impact share prices and lot structures. The derivative segment makes adjustments on the last cum-date to ensure the economic value of market positions remains equivalent on cum-date and ex-date.

Core Adjustment Principles

1. Economic Neutrality: Position adjustments preserve the relative monetary value and moneyness (ITM, ATM, OTM status) of positions.
2. Timing of Adjustment: Executed on the last trading day on which the underlying stock trades on a cum-basis in the cash market.
3. Contracts Covered: Applied universally across all open positions, exercised positions, and assigned positions.
4. Parameters Adjusted: Strike price, market lot size, and open position quantity.

Formulas for Corporate Action Adjustments

1. Bonus Issue (Ratio A : B)

For every B shares held, A additional bonus shares are issued.

Adjustment Factor = (A + B) / B

New Strike Price = Old Strike Price / Adjustment Factor

New Market Lot = Old Market Lot * Adjustment Factor

New Position = Old Position * Adjustment Factor

2. Stock Splits and Consolidations (Ratio A : B)

Where A represents old shares and B represents new shares after split/consolidation.

Adjustment Factor = B / A

New Strike Price = Old Strike Price / Adjustment Factor

New Market Lot = Old Market Lot * Adjustment Factor

New Position = Old Position * Adjustment Factor

3. Rights Issue (Ratio A : B)

Where A is the number of rights shares offered for B existing shares held, C is the rights premium, D is the face value, X is the existing strike price, and Y is the existing lot/position size:

New Strike Price = ((B * X) + A * (C + D)) / (A + B)

New Market Lot / Issue Size = Y * (A + B) / B

4. Rounding Off & Fractional Settlement Methodology

To prevent fractional contract sizes and forced closures:

1. Calculate exact monetary value of position prior to corporate action.
2. Calculate position value using exact unrounded adjustment factors.
3. Round off strike price and market lot to standardized tick/lot steps.
4. Re-compute final position value and adjust strike or lot size slightly to eliminate valuation cash discrepancies without requiring forced position unwinding.

5. Dividends Adjustment Thresholds

• Ordinary Dividends (< 10% of Stock Price): Dividends below 10% of the market value of the underlying equity stock are considered ordinary dividends; no adjustment is made to derivative strike prices.
• Extra-ordinary Dividends (>= 10% of Stock Price): Dividends equal to or exceeding 10% of the market value of the underlying stock are extraordinary dividends; full adjustment is made to strike prices.

Key Terms & Concepts

• Market Wide Position Limit (MWPL): The maximum open position allowed across the entire market for a single stock derivative, capped at 20% of non-promoter free float shares.
• 95% MWPL Ban: The automatic restriction triggered when open interest in a stock exceeds 95% of MWPL, restricting trading strictly to position-reducing trades.
• Adjustment Factor: The mathematical ratio used to modify strike prices, lot sizes, and position quantities following corporate actions like bonus issues or stock splits.
• Extra-ordinary Dividend: Any dividend payout meeting or exceeding 10% of the stock's market value, which mandates a downward adjustment in option strike prices.

Key Takeaways

1. Position limits exist at TM, client, MWPL, and institutional (FII/MF) levels to maintain market stability and limit systemic risk.
2. MWPL is capped at 20% of free float shares; crossing 95% MWPL bans fresh positions, and normal trading resumes only when open interest drops to 80% or below.
3. Mutual Funds participate in derivatives under the same position limits and framework as Foreign Institutional Investors (FIIs).
4. Upfront initial margin collection is mandatory, and both CMs and TMs must report client margin collections daily to NSCCL.
5. Corporate actions maintain position value neutrality on ex-date; ordinary dividends (< 10%) require no adjustments, whereas extraordinary dividends (>= 10%) adjust strike prices.