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National Stock Exchange (NSE), the country’s largest bourse by volume, has discontinued the ‘Do Not Exercise’ or DNE facility for traders of stock options from March 30, 2023. The move effectively turns equity option buyers’ right into an obligation. The facility will, however, remain operational for Index Options traders.

The DNE facility, introduced in 2019, was discontinued in 2021, and reintroduced in April 2022 by SEBI’s Risk Management and Review Committee to “safeguard the interest of the options traders”.

What exactly is the Do Not Exercise facility?

As we know, an options contract gives the holder the right, but not the obligation to buy or sell an underlying asset at a specified price on a specified date.

Under the DNE facility, the traders could direct their brokers to not exercise their rights and automatically square off their positions on a cash-adjusted basis. So, if traders did not want to exercise the right to receive or give deliveries, their trades would get squared off and they would have to pay only the residual amount.

Let’s consider this with an example. Assume Nikhil bought Reliance 2500 call (lot size 250) by paying a premium of Rs 50 per share (or Rs 50 x 250 = Rs 12,500). On the day of expiry, if Reliance closed at Rs 2,600, the premium would have increased to Rs 100. Under the now-withdrawn DNE facility, Nikhil could have instructed the broker to exit his call option position at a profit of Rs 50, and pay him Rs 25,000, effectively making a profit of Rs 12,500.

With the DNE facility being withdrawn, traders will no longer have the auto square-off option. So, if Nikhil is still holding the Reliance call at the end of expiry, he will have to keep Rs 6.25 lakh in his trading account to buy 250 shares of Reliance at Rs 2,500 each. Similarly, the seller of this option will also have to keep 250 shares of Reliance in their account ready for delivery. Failure of either party to meet this obligation will result in penalties.

In short, all In-The-Money (ITM) single stock options that are not squared off at expiry will have to be physically settled by taking or giving delivery of shares.

How will this impact traders?

The move could result in losses for traders if they do not have enough cash or stock in their account on the day of expiry of the options contracts. They may have to face penalties if the stock option goes into delivery.

DNE became relevant when the market watchdog Securities and Exchange Board of India (Sebi) introduced physical settlement in the derivatives segment in 2019. The DNE facility was reintroduced in 2022 after several concerns were raised over trading mishaps when traders failed to meet the settlement obligations during option contracts’ expiry.

Discontinuing the DNE facility is likely to hit the retail trading volumes in single stock options. The retail traders, without the DNE facility, cannot afford to wait until the last minute to close out their open positions. Even if an option is just slightly in-the-money, it can significantly add to the trader’s costs.

As a result, single stock options may become a riskier and less attractive investment option for traders, who may be forced to close their positions hastily or have them automatically closed by their broker at potentially unfavourable prices.

How can traders avoid a loss in the absence of the DNE facility?

It is essential for options traders to be vigilant on the expiry days. Traders can choose to square off their positions early, before the expiration date of the options contract which can help them minimize their exposure to potential losses due to market volatility or unexpected price movements.

Without the DNE facility, traders need to monitor their positions closely to ensure that they do not become in-the-money by too great a margin. This can involve closely following market news and events that could impact the price of the underlying asset.

However, if traders want to opt for the delivery, they should keep full money in their demat accounts to avoid penalty.

While the removal of the DNE facility may create some uncertainty and challenges for retail investors, it does not necessarily mean that they need to worry. Investors can adapt their strategies to the changing market conditions and continue to trade options and futures contracts with appropriate risk management strategies in place.

Disclaimer: Investment in securities market are subject to market risks. Read all the related documents carefully before investing. Please refer the Risk Disclosure Document issued by SEBI and go through the Rights and Obligations and Do’s and Dont’s issued by Stock Exchanges and Depositories before trading on the Stock Exchanges. Brokerage will not exceed the Exchange prescribed limit.