Price recovery or price discovery: what do you prefer as a stock market trader or an investor?
As you would know, derivatives are meant for price discovery. As Securities and Exchange Board of India (SEBI) describes, derivatives markets reflect the expectation of spot prices in the future.
Since stocks in the derivatives segment aren’t constrained by a fixed circuit limit, they often experience rattling volatility in the cash market. Thus, what happens in the Futures and Options (F&O) market also affects individual investors in the cash market.
According to SEBI, 40 scripts (out of 199 traded in the derivatives segment) experienced intraday fluctuation of over 20% in last six months.
- Out of these, 29 experienced the intraday volatility of 20%-30%
- 5 scrips witnessed the intraday movement in the range of 30% to 40%
- And 6 stocks swung in the range of 40%
Did you know?
The ratio of derivatives turnover to cash market turnover spiked up from 2.9 times in 2009 to 29 times in the current financial year—one of the highest in the world.
Such skewed derivative market operations, in the absence of corresponding cash market participation, sometimes gives rise to massive speculation.
To curb excess speculation in the derivatives market which affects gullible investors in the cash market for no fault of theirs, SEBI has swung into action.
In recent times, it took some steps to strengthen fair price discovery without disturbing the orderliness. They are as follows:
- As per the new norms, if a stock present in the F&O segment falls 9.9%, the flexing window will open only if there are at least 25 trades and 5 trades from Unique Client Codes (UCC) on both sides. For example, if an F&O segment constituent falls from Rs 100 to Rs 90.1%, the next window for another 5% fall will open only if there are minimum 25 trades and 5 buy and sell trades each. This is expected to help weed out the effects of erroneous trades.
- The capital market regulator has also decided to phase out the cash settlement of stocks present in the F&O segment. It has already issued a circular in this regard on December 31, 2018.
Bottom 50 stocks as per their average daily market capitalisation in December 2018 will move to the physical settlement from April 2019 onwards. The next 50 will follow suit from July 2019 and the remaining ones will move to physical settlement from October 2019 onwards.
On February 11, 2019, SEBI released a discussion paper which proposes three additional measures to protect investors in the cash segment from extraordinary price movements guided by the derivative market action. SEBI has sought comments from all stakeholders by February 20, 2019.
More protection for investors
Possible impact on markets
- Price discovery may become obscure. Derivative volumes might fall on account of the physical settlement of equity derivative positions and proposed circuit limits on stocks available in the F&O segment.
- According to a SEBI report, Index derivatives account for 82% of total turnover in the derivatives market. Which will remain unaffected by the proposed norms
- Until Stock Lending and Borrowing (SLB) takes off, short selling might temporarily cool off. Nonetheless, SLB will open up additional income generation opportunity for long term investors.
- It also remains interesting to see how a drop in volumes in the F&O space affects the bid-ask spreads in the cash market which would eventually decide the impact cost. According to the National Stock Exchange, impact cost represents the cost of executing a transaction in a given stock, for a specific predefined order size, at any given point of time.
SEBI has proposed corrective steps to stave off extreme market speculations. What do you think about them?
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