Futures

SEBI has now specified new lot size standards for all futures/options contracts:

Example: The lot size for an underlying with a price of Rs. 250, i.e., in the
price band of Rs. 201-400, will be 1000 shares.

This will differ dramatically from the current system – where lot sizes are anything that NSE seems to want. SBI’s current lot size is 132, RELINFRA is 276 and HINDALCO 3518. The new system will keep all lot sizes close to something we can remember.

So how did these odd lot sizes come into play? When a company splits, gives bonuses or has a rights issue or demerger, the lot sizes of its shares' futures contracts are split accordingly. If a stock with a lot size of 100 and price of Rs. 1000 has a 40% rights issue at a certain price, the stock on the post-issue date will reduce by a certain price (to accommodate the new shares available) – if that reduces the price to, say, Rs. 750, the lot size needs to go up to Rs. 133.33 just to reflect that fact – usually that’s why these odd lot sizes come into play and remain there.

So if lot sizes need to be changed, they will happen only in further contracts. Currently contracts till March are traded, so expect changes in the April contract onwards.

The SEBI circular says the new-contract rule will only apply if the lot size is “higher” than the old one. That is after this change goes through the first time. So if I hold one future lot (1000) of a share that was Rs. 300 but goes up to Rs. 450, the lot size will become 500 shares and I will then have two lots, so my holding remains the same. This will happen in between expiries too, in a middle of a month (currently lot size changes seem to happen on Expiry days)

This should help with some of the stocks that have had runaway movements and whose contract sizes are over Rs. 10 lakhs, way too expensive to use on a reasonable portfolio.

The change will not apply to index contracts like Nifty.

Note that this is considerably different from the U.S. where the lot size is 100 shares regardless of where the underlying share trades. In India the idea is to maintain a future lot between 2 and 4 lakhs; these are low limits that haven’t changed for the last 8-9 years, and have today made F&O trading a lot more affordable.

19 stocks have had their lot size divided by four, 122 are cut to half and 2 have been rounded off after division. Only one stock, Sterling Biotech, has seen the lot size go up.

The last time this kind of operation was announced was in December 2008, increasing lot sizes for contracts starting March 2009. And now, this will happen only for contracts expiring in September 2009, i.e. new contracts introduced after the June expiry. Lot sizes for the June, July and August expiries do not change.

Why not? Because they've been traded for the last few months - remember that the June contract opened after the March Expiry, i.e. on March 27th. But there's nothing wrong with doing it technically, if you're cutting down lot sizes of course...you just multiply the held lots by the same number you are dividing the lot size. I think the NSE wants to do the same thing both ways - when they increased the lot sizes they *had* to wait three months.

Also the reason why they always choose a multiple is to let calendar arbitrage happen - where I would like to buy one contract and sell another, and thus hedge.

Overall, the idea is good and should help in liquidity and attracting retail participation. It may soon be time to revise contract sizes again, though I don't know which way!

• Mini contracts on equity futures, apart from the Mini Nifty. That happened almost automatically as some stocks fell 90%, but now they may be formalised.
• LEAPs or long term options on stocks and indices. Currently on Nifty only, the recommendation is to do this for stocks and other indices also.
• Futures and Options on the VIX. Useful to hedge option contracts.
• Options on Currency futures. These are unbelievably useful.
• Bond Indices and related F&O. Oh goodness, finally, one can short bonds too. If this is approved.
• Futures on other currencies: Yen, Euro, Pound.
• Strategy based ETFs - like covered calls and puts.
• Credit derivatives, exchange traded or settled.

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Luckily the Nifty lot size hasn't changed, but most stocks have. Two stocks, Sterling Biotech and Lupin labs have had their lot sizes decreased by half (their prices are still way too high!) but everything else has seen a lot size increase.

Unitech, for instance, has seen its lot size go up from 900 to 9000, since the price has fallen to 1/10th of its highs. Puravankara has shot up from 500 to 7000 - that was what was needed to move the price to 2 lakhs.

I find some of these lot sizes very difficult to understand - like Reliance Capital is 138 and the new lot size is 552. The 138 would have been because of a corporate action (I think this was the big reliance capital venture merger) but why not rationalise it now? Yes, you will impact some calendar spreads and margin calculations but that is definitely easy; if you can do it one way during a corp action, you can do it another way during a new contract opening.

In any case the new lot sizes are only applicable in March 2009 and onwards - meaning, existing contracts will continue to use the same lot sizes - only the new contracts opened in January (for March 2009) will carry the new lot sizes.

Cross-margining is essentially allowing cash positions (shares in a DP account) to offset margin requirements for hedged futures or options positions. Let's say you had 75 shares of Reliance, and someone told you that dude, you have lost so much money, why don't you write covered calls instead?

You ask, "What the hell is a covered call?"

He launches into a long explanation on futures and options and you eventually ask, "This is great, so what do I do?"

A few days ago, he would tell you: "Sell your shares. Then buy a futures contract. Then sell a call option at strike price 1200".

You're wondering - why should I sell my shares and buy a future? What's the point, it's the same thing: I have a long position on Reliance. If I write a call option, I pocket some premium in exchange for giving someone the right to buy my shares at a certain price. I have the shares. So why bother with a future? And why sell my shares?

The old margining system expected a certain margin per derivative position. A long future position has certain margin, and that can offset the margin required for a short call (a covered call is long future, short call). This meant that if the margin for a long Reliance future position was, say, 40K, I wouldn't need to add money on it to write a call option on Reliance.

But this margin cancellation doesn't apply if you held shares. Futures position margins could cancel options positions, but that didn't work if you held shares in your DP account, instead of the future. The "cross-margining" that is being introduced now, allows you to margin "cash" market positions against "derivatives" positions.

Unfortunately this has not been allowed for options just yet - only for cash versus futures. The above example was just an explanation, but I hope they will consider it for cash vs. options too.

A huge beneficiary is arbitrage. I could buy shares and sell futures, making the resulting arbitrage (typically 1-2% a month, but can be wiped out if you have high transaction costs) cheaper. Earlier you had to pay 100% of the cash value, and around 50% of the future value upfront - so to arb Reliance cash versus Reliance future you had to pay 1.5 times Reliance shares value. Now it's 1x, because of cross-margining, which will result in better returns on capital and eventually, tighter spreads.

This type of cross-margining was earlier available only to institutions (since May) but now it's been opened out to all players.

For that purpose though, you have to open two accounts, and exchanges have to issue guidelines to this effect. It might end up taking a few weeks before that happens though.

This is an interesting step, but not good enough - once cash can be offset with options, we'll see activity perk up in writing calls. SEBI has a lot more to do in terms of addressing the lack of activity in the F&O segment - today, volumes were a dismal 33K cr!

The rule earlier was that when there were less than three days to a contract's expiry, margins of calendar spreads would not cancel each other out. So, if you had bought an August future for say Rs. 100, and sold the September future for Rs. 110, the margins would usually offset each other (since your risk is much more than the difference between the two contract prices). But till now, for the last three days before August expiry, your broker would demand double margin - one for each contract because the margins weren't allowed to offset each other.

This wasn't very good for arbitrage strategies, where tiny discrepancies are taken out and to give a good return, leverage is necessary. With this clarification that bit is solved.

Calendar spreads may involve options too - and it is here where the unwinding hurts the most. Double margins are unnecessary especially when you have a reasonable liquidity in both (offsetting) contracts. On the other hand, it promotes a lot of leveraged positions where suddenly on the day after expiry, a trader may find himself needing to put up a huge amount as margin (as the offsetting position expired). We assume that calendar spreads are only taken by people who know what they are doing; but it often turns out that they don't, even if they are large, experienced investment banks.