New Delhi [India] September 10: On August 30, 2024, the capital markets regulator, the Securities and Exchange Board of India (SEBI), made some significant announcements for the futures and options (F&O) segment.
The regulator proposed to introduce measures that will make sure only high-quality stocks are traded in the market. This led to a reshuffling of stocks in key indices such as the Nifty 50 and Sensex.
Given the significance of the SEBI announcements for investors, we reached out to Mr. Hemant Sood, Managing Director of Findoc Investmart.
The Changes in F&O Stocks’ Eligibility Criteria
SEBI aimed to improve the quality of stock by altering the eligibility criteria for the listing of stocks in the F&O segment.
This will effect change on multiple fronts. To begin with, the regulator has announced an increase in the market-wide position limit (MWPL), median quarter-sigma order size (MQSOS) and average daily delivery value. Along with these changes, it has said to introduce a product success framework (PSF) for the exit of single-stock derivatives.
Based on our discussion with Hemant Sood, here is some clarity on the topic.
Market-Wide Position limit (MWPL) for Market Growth
MWPL is a regulatory mechanism used to prevent market manipulation, control risk and fuel market growth. To explain, an increase in the MWPL allows for a greater number of open contracts across all market participants, thereby permitting larger overall positions.
It also improves liquidity by easing and optimizing trading, as more contracts can now be opened and closed without significant price impacts. Further, it also contributes to market depth, making room for larger transactions without destabilizing prices. This benefits institutional and retail investors alike.
Sharing his advice to the investors, Mr. Sood said, “The increase in MWPL signifies the growth-facilitating intention of the regulatory body. As, when MWPL is up, the time becomes ripe to take a fresh look at your investments. Maybe you could mix things up a bit or even go bigger on some of those derivative products that are easier to get into now. But don't get carried away. Make sure you're also strengthening up your safety net as you expand your portfolio. The key is finding that sweet spot between opportunity and playing it smart.”
Median Quarter-Sigma Order Size (MQSOS) for a Clear Picture
MQSOS is a metric that is used to assess the liquidity of a stock in the market. It helps in determining the typical order size that can be processed without having a significant impact on the stock's price.
As the name suggests, it is the median size of an order and the change it might bring should not be more than a quarter of the standard deviation in the stock's price.
An increase in MQSOS value means that larger orders can be executed without disturbing stock prices, an important consideration for investors trading in large volumes. It will lead to the inclusion of stocks with sufficient liquidity, maintaining stability in the derivative market while preventing excessive volatility caused by large trades.
MQSOS also mitigates systemic risks by ensuring that no single entity controls a significant portion of the market.
Easing the concept behind, Hemant Sood said, "Overall, MQSOS is just a technical way of saying 'typical order size' for a stock.
Now, let’s break it down. There are three aspects to it, first is Median, second is Quarter-Sigma, and third is Order Size. Median, picture a line of all the orders arranged from smallest to largest – the one in the middle is our median.
Next comes the Quarter-Sigma. It basically uses volatility to determine how large an order can be without impacting the stock price significantly. The catch is we're only looking at a quarter of that volatility. So, if a stock has a volatility of 4%, we will only allow the order size to move the price by up to 1%, before it becomes too impactful on the stock price. And this covers the ‘Order Size’ aspect as well.
So, when we put it all together, MQSOS gives us a good idea of what a 'normal' trade for a particular stock looks like, without letting the really big or really small trades disturb the market.”
Average Daily Delivery Value in the Cash Market
This refers to the average value of shares that are actually delivered as a part of transactions over a specified period. It focuses mainly on transactions where the ownership is being transferred and not on the trading of positions, and this is where it differs from the total traded volume.
It indicates how much real trading is happening, as opposed to speculative trading where people don’t bother taking stock delivery. Plus, it provides a decent idea of the depth of the market in terms of actual assets changing hands.
On this measure, Hemant Sood had a proper explanation, "I will give you the best example to understand 'average daily delivery value’. It's like measuring how many people are actually buying groceries, not just window shopping. Getting it, right? So, essentially, it is how many stocks are actually changing hands each day on average. We're not considering all the buying and selling - just the trades where someone's keeping the shares. This gives us a clear idea of real, long-term trading activity in the market, ignoring speculative moves. This is critical for the robustness and stability of the market”
Product Success Framework (PSF) for the Exit of Single-Stock Derivatives
PSF is a set of criteria used to evaluate derivative products. In the case of single-stock derivatives, it assesses their performance and viability by considering their liquidity, trading volume, and compliance. It compares them against the regulatory standards and based on the results determines whether they should continue to be listed and traded.
PSF ensures that derivative products that meet the needed standards and regulatory compliance are available for trading and weeds out underperforming derivative products. This way, it improves the overall efficiency of the market.
On PSF, Hemant Sood commented, “It's like a quality check for derivatives that filters out the weak performers. This way, investors don't get stuck with products that are hard to trade. Thus, keeping the market healthy and giving investors more confidence.”
What does It bring to the investors?
Reduced Risk Exposure
With the new criteria for stocks in the F&O market in place, investors will get greater exposure to more rigorously vetted stocks. Thus, it will bring more liquidity and better performance at the same time, they will be better protected against the risk of investing in highly volatile or manipulated stocks. Investors will be more confident as the chance of erratic price swings will go down or be subject to market manipulation.
Diversification Opportunities
Second, with new entries to the indices, investors will have a greater option to diversify as now there will be new, potentially high-growth companies. Thus, they can spread risk and capitalize on the sectors with high growth potential.
Informed Investment Decisions
Next, under the updated eligibility criteria, stocks will be required to meet stricter liquidity and performance benchmarks.
This will portray a clearer picture of stock performance and help investors make more informed decisions. They will have improved data and indicators while choosing stocks for their portfolios, ushering in more strategic and data-driven investment decisions.
Investment Preparation for the Run-up to the Changes and After that
Until these changes go into effect, investors need to remain responsive to market shifts. First, they need to stay informed and actively research their effect on their portfolio. Second, based on their research, they should keep reviewing and rebalancing to include compliant entrants and exclude underperformers from their portfolio, aligning it with the latest developments in the space.
Once the measures go live, investors will need to adapt as stocks are added or removed from indices. Here, a smarter way would be to consult a financial advisor for professional insights, especially during time of transition. Lastly, they can implement risk management tools like stop-loss orders and diversification to protect themselves from high market volatility.
Conclusion
As SEBI introduces these measures, investors stand at a pivotal juncture. The good thing is the market is poised for a healthier, more robust trading environment. The insight provided by Hemant Sood will be a great starting point as they both caution and elate.
Investors are encouraged to reevaluate their strategies considering these changes, ensuring that their portfolios are better positioned to benefit from the upcoming development.
This article is for informational purposes only and does not constitute financial advice. Investing in stocks involves risk, and past performance is not indicative of future results. Readers should conduct their own research or consult with a qualified financial advisor before making any investment decisions.
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