The National Stock Exchange will reintroduce a ‘Do Not Exercise’ (DNE) stock option instruction from April 28, 2022 onwards. With the reintroduction of this DNE instruction, a stock market investor can now minimise his/her loss and eliminate the risk of a physical delivery to a certain extent.
Let’s find out more about how this DNE instruction can help an investor minimise a potential loss in a stock option trade and also help eliminate physical delivery risk up to a certain extent.
Challenges To The Removal of DNE
The removal of DNE in October 2021 created a risk of physical delivery. For instance, if a client did not settle his option contract before expiry, he would need to take or give delivery of the respective stock mandatorily, irrespective of whether or not he had sufficient funds in his account.
If an options contract is held till expiry, then it needs to be settled using physical delivery i.e, the shares are moved in the demat account after payment of the full value of the shares in cash. If the option contract is settled before expiry, then no further settlement is needed.
In case the client holds the contract in his demat till expiry and does not have any cash, or declares bankruptcy, then a contract default occurs, and legal action and a whole lot of other processes follow. The money, however, will have to be paid for the shares, regardless of whether the client has the cash or not, since he did not sell the option contract before expiry.
In 2019, the Securities and Exchange Board of India (Sebi) mandated that all options contracts be physically settled.
DNE was first introduced in 2017 when the Securities Transaction Tax (STT) used to be charged for the entire contract value, unlike today, where it is charged for the option premium value. By using a DNE instruction, clients could tell their brokers not to exercise the option strike price if the STT amount was greater than the premium value of the respective option contract. But it was discontinued in October 2021 as the STT tax law changed.
What Makes DNE Option Feasible?
On December 30, 2021, the shares of Hindalco closed at Rs 449.65. This meant every long put holder of the Hindalco 450 PE option contract who did not settle his trade before expiry had to deliver the shares mandatorily. One lot of Hindalco 450 PE had 1,075 shares, so the total value of one lot was Rs 449.65*1,075=4,83,373.75. So, either the holders of this put option had to give this amount of money in cash to their brokers, or, they could default, and then this would create a systematic risk for the broker’s operation.
Let’s say for instance that Hindalco is trading at Rs 450. Assuming the monthly stock put option Hindalco 450 PE is trading at Rs 1.2 strike price (the price at which the put or call option can be exercised) for 1 lot (1075 shares), so the money required to buy this option will be Rs1.2*1,075=Rs1,290. The broker will need to collect Rs 1,290 for this trade from you. But if you fail to close this trade before the option expires, then you will have to pay Rs450*1,075=Rs 4,83,750 (assuming Hindalco stock is trading at Rs450/share) at the contract expiry.
Most stock brokers do not allow leverage trading in options, and hence collect the full option premium price upfront. Now, if a large number of clients default on their obligations to pay for their option contract, then it could create a ripple effect in the market. This is why implementing a DNE instruction could help minimise this risk of default, and protect brokers, investors, and other stakeholders.
Under the DNE option, you can explicitly tell your broker by signing a DNE form to settle the trade if the price of the underlying stock falls below the option price. Though you may still suffer a loss, it won’t be that severe. This phenomenon where the price of a stock goes below the option price is called an out of money option.
With the re-introduction of the DNE instruction mechanism, clients will be able to tell their brokers explicitly not to exercise their option, and automatically settle their out-of-money (i.e., if the underlying spot contract price falls below or option price) and options contracts.