Why has the NSE reintroduced the Do Not Exercise instruction in stock options and what are the implications of the same?

There seems to be some positive news for the F&O traders. NSE will reintroduce the “Do not exercise” instruction when trading in stock options effective from 28th April when the May F&O contracts will start trading. The DNE option had discontinuing in October 2021. The Do not Exercise (DNE), instruction was introduced in 2017. The idea was that stock options traders could chose DNE for cash-settlement of options contracts.

Things changed after the introduction of the physical delivery settlement from October 2021 since the DNE option had apparently become redundant. In the new scenario, the risk of paying STT at a relatively higher rate was not there and hence the DNE option was scrapped. However, one loophole was the case of extreme volatility in stock prices in the last hour of F&O settlement. How did the volatility result in big stock option losses?

It happened in specific cases where the stock option would normally be out-of-money but the options suddenly became in-the-money at the time of the expiry due to extreme volatility in the stock price. In the current system, traders have to either square off their existing ITM positions before expiry or ensure physical delivery. For a put buyer it became an equivalent short position on stock, and thus raised the huge risk of auction losses.

For instance, if your Rs.150 put option on a stock is OTM at Rs.165, and if the last minute volatility takes the stock price to Rs.145, then you have a problem of auction losses. This is not hypothetical as it actually happened in case of Hindalco when the price crashed on the January 2022 expiry day and caused huge auction losses for those who had left the OTM options assuming it would expire worthless. This is what CNE would avoid.

Now, effective 28-April, the Do Not Exercise (DNE) option will be introduced so the traders in stock options can give explicit instructions to their brokers not to exercise the option. Instead they can automatically square off out-of-money positions. This lacunae in the existing system will be plugged with the reintroduction of the CNE system. Options traders, especially put option buyers, can breathe easier now.