counterparty default risk in stock market options trading
How to avoid counterparty default risk in the options market?
The stock market has various instruments and strategies for a varied group of traders, it depends on you, and how to take advantage of it. You can either win constantly or completely bankrupt by losing your capital in the options market. Counterparty default risk is very important to understand, to survive in the stock market in the long run.
Be it bank nifty options or some other underlying asset, you should totally try to understand the universe first before trying to jump in and being injured.
HERE IS MY PERSONAL HABIT TRACKER FOR THE STOCK MARKET
Follow the checklist below in the table. This might help you with a perspective on how things should be handled right at the beginning of your stock market trading journey. This when followed effectively can also help you avoid the traps like counterparty default risks.
When you have spent some time with the table above, don’t think that you have become a pro already. The process is not complete unless you have experienced enough with multiple cycles in the market. Call and put in share market always open the doors for too many ideas. There seem to be countless ways to work on the stock market. Stock option tips that are completely unauthorized have eaten into the pockets of many traders, and there have been huge losses owing to the same.
As a word of caution, it should be maintained that richdaada does not provide any stock tips, nor is it entitled in any way to any bodies to provide legal or financial advice. Please follow your own due diligence and speak to your financial advisor before investing, etc. Everything in this article or this website is for educational or entertainment purposes only.
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THE BACKSTORY OF COUNTERPARTY DEFAULT RISK
Stock market options trading is a high risk, high reward game. It is for high-risk-loving people. This is also a particular place where there is a counterparty default chances as well. Option volatility and pricing strategies are something that is not everybody’s cup of tea. Despite following the table, and checking to list every item. You could lose!
While trading with options in the stock market things like the counterparty default risk can grab you by the neck. So, let’s understand this through history to find out more about the systems and procedures that operate in the stock market.
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So, inherently F&O positions that were held until the expiry used to be settled in cash as per the price of the stock. But, from October 2019, through a SEBI circular, it was stated that F&O positions that are held till expiry will be settled through physical delivery of the underlying stocks.
Here, the quantity to be delivered/received is basically the Market lot multiplied by the Number of contracts that result in delivery settlement. Needless to mention, the amount is astronomical when compared to the overall margins spent by a retail player in the market for one such trade. Most people have small margins blocked for the trades at the initial level. So, failure to comply would mean a default. So, that’s your counterparty default risk situation.
NEW RISK THAT LED TO THE COUNTERPARTY DEFAULT RISK
If you are aware of the basics of option prices and strike price management, you would know very well what are the possible ways to mitigate risks. In fact. things were not so daunting as there was already in effect a system called the DNE (Do Not Excercise) facility for close-to-market option strikes. Option volatility and price action strategies are great ways of making money in the stock market.
Stocks are a good way to make passive income but there are safer options for passive income too.
However, a new risk was posed from October 2021 when a circular was published which meant that the Do Not Excercise Facility will be unavailable from 14th October 2021.
You can read about the new circular from National Stock Exchange here
But what does this mean for the stock market traders?
The DNE facility would enable brokers to not to exercise option strikes where the STT amount is more than the premium of the ITM option. With STT revisions, the DNE could be done away with. But, now, without DNE, there is a new risk altogether.
And that could mean counterparty default risk.
A greater possibility of having to take or give the delivery of underlying stocks or assets by the client him/herself.
Failure to do would mean a default against a counterparty. It would incur a heavy penalty from the exchange owing to the auction penalty procedures, etc.
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Peculiar cases of counterparty default risk.
Call and put option in the stock market will need some understanding from your end before you proceed with this section. But, when you do get the drift of what constitutes the risk, do come back to this page and give it a read. You will be able to visualize the issue more clearly. It is not as difficult as it might appear on the first go. Your stock trading strategies might work well in any market, but things like the counterparty default risk may not be avoided.
There can be situations where an out-of-money put option contract can suddenly be in the money on the expiry day. Even if a trader wants to exit, he might not be able to square off due to low liquidity (very low buyers or sellers) owing to the worthlessness of the expiring contract. In such cases, one must choose to get the entire stock in his/her Demat account with the full amount being paid, again failing to do so may result in short delivery. The auction penalty at the end of T+3 days would incur significantly higher losses eventually.
Many have been complaining all over the internet about such rules. Retail traders have been affected and the brokers are fearing undue systematic risks in the long run. Apparently, a trader had been crowdfunding to meet the penalty amount. Ideally, a client should have been given more power to instruct a broker on whether or not to use DNE at a discretionary level.
What is the solution to things like counterparty default risk.
As a solution to counterparty default risk - It’s found that the brokers' associations have requested a trading session post the usual hours for the F&O stocks, especially with the sole intention of settling the expired contracts without hurting the parties a lot.
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Conclusion
The regulations and the circulars may have changed significantly by the time you are accessing this article. Remember to do your own due diligence and follow the latest updates on the broker or exchange platforms only. Especially for things like counterparty default risk you cannot take chances in the stock market.
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