SEBI Proposes Converting In-the-Money Options to Futures Before Expiry

The Securities and Exchange Board of India (SEBI), the market regulator, on Thursday proposed a framework aimed at converting ‘in-the-money’ (ITM) single stock option contracts into futures one day before their expiry.

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At present, stock derivatives must be settled physically. This implies that if an ‘out-of-the-money’ (OTM) option unexpectedly becomes ITM on the expiry day, the holder is required to provide cash or securities for physical settlement. SEBI has expressed concerns that this requirement could create risks for the settlement process, particularly when large positions are involved and the holder is unable to meet the obligations.

SEBI’s proposal suggests that ITM options, instead of leading directly to physical delivery obligations upon expiry, would first convert into stock futures on the day before expiry, known as E-1. These stock futures positions could then be squared off or closed on the expiry day (E).

In options trading, a ‘call’ or ‘put’ option is tied to a pre-set strike price, which determines the value of trading the contract upon expiration. An OTM option occurs when the market price of the underlying asset is less favorable than the strike price, making the exercise of the option less advantageous. Conversely, an ITM call option represents a profit opportunity, as its strike price is lower than the current stock price.

Under this proposed framework, trading on the expiry day would be limited to futures contracts, although open futures positions would still be settled through delivery. A similar system is already implemented in commodity markets.

The regulator highlighted that this change is designed to mitigate settlement risks that may arise if an OTM option turns ITM due to sudden price fluctuations on the expiry day. SEBI also clarified that the proposed framework is unlikely to require significant modifications to the existing margining system.

Previously, in August 2017, stock exchanges introduced a “Do Not Exercise” (DNE) mechanism for cash-settled stock options, helping traders avoid negative payoffs caused by the securities transaction tax (STT) on the notional value of contracts. However, after the STT was adjusted in 2019 to apply to the intrinsic value of options, the DNE framework was discontinued in 2021 as its primary purpose became obsolete.