Do Not Exercise Instruction is back on the NSE; how will it benefit investors?

The National Stock Exchange of India (NSE), with effect from April 28, 2022, has reinstated the "Do not Exercise" function in stock option contracts, which is a huge relief for stock dealers. A stock market investor can now reduce loss and, to some extent, minimize the risk of a physical delivery with the reinstatement of this DNE instruction. Sebi mandated a physical settlement of stock derivatives in October 2019. That is, you will be compelled to take or give delivery of stocks when the option is exercised if your position in any stock option contract is open on the expiry day. Only if the contract is ITM (In-The-Money) at the point of expiration does it become exercisable.

"It may be noted that facility to indicate 'Do Not Exercise' instruction on expiry day will be re-introduced in Stock Options contracts with effect from April 28, 2022," read a new circular from NSE Clearing Ltd., a division of NSE, dated April 11.

What is DNE?

The mechanism, which was unveiled in 2017, served as an insurance policy for options traders when options contracts were settled in cash. During the moment of cash-settlement of options contracts, it is a fail-safe for options traders, according to Manoj Dalmia, founder, and director of Proficient Equities Limited. According to a notice from SEBI, if a stock's spot price closes below the strike price, the trader who is holding the put option on it must either close out his position before it expires or arrange for shares to be purchased at auction.

What Happens Currently?

The existing system required traders to either square off their open in-the-money bets before the contract's expiration or guarantee physical delivery. Given that he would have to purchase the shares from the auction and deliver them to the put writer, the position for a put option buyer who held in-the-money contracts at the time of expiration was exceptionally dire.

The Securities and Exchange Board of India (Sebi) mandated physical settlement of all options transactions in 2019.

The Securities Transaction Tax (STT), which is now only levied for the option premium value, was not charged for the total contract value when DNE was first introduced in 2017. Clients could instruct their brokers not to execute the option strike price by utilizing a DNE instruction if the STT amount exceeded the option contract's premium value. But due to a change in the STT tax law, it was stopped in October 2021.

There was a possibility of physical delivery because DNE was removed in October 2021. For instance, regardless of whether he had enough money in his account, a client would be required to take or give delivery of the relevant stock if his option contract was not settled before it expired.

When put options on Hindalco Industries that were out-of-the-money and slated to expire in December suddenly became in the money due to a sharp decline in the share price during the session's final hours, several traders claimed that they had suffered enormous losses.

Many retail investors who purchased out-of-the-money put options from Hindalco experienced catastrophic losses, which were partly caused by their ignorance of the new regulations that went into effect in October 2021.

Market participants earlier this year, including Nithin Kamath, co-founder of Zerodha, emphasized that the removal of the "Do not exercise" option has increased the danger of significant losses for traders whose holdings in the out-of-the-money options unexpectedly became in-the-money at expiration.

How Will Reintroduction of ‘Do Not Exercise’ Options Help Traders

With the return of "do not exercise" options, traders will once again be able to specifically direct brokers to forego exercising the option and automatically square off their out-of-the-money holdings.

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