An F&O ban is a provision whereby stock exchanges can put a temporary ban on the futures and options contracts of stocks that exceed a certain threshold. The objective of the ban is to safeguard investor interest, protect market integrity, and curb extreme price volatility. While opening new positions during the F&O ban is not allowed, you can exit the market or square off your position.
Why are F&O bans placed by stock exchanges?
The F&O segment of the financial market enables investors to open positions in commodities, currencies, and stocks, among other asset classes. However, it may be interesting to learn that these markets see a high level of leveraged trades followed by a high level of risk. Thus, F&O bans are essential tools through which stock markets protect the market integrity and investor interest.
Why do F&O contracts enter a ban period?
In the context of the Indian financial market, F&O bans are placed on stocks where the total open interest of contracts in the futures and options segments goes beyond 95% of the stock exchange-defined Market Wide Position Limit (MWPL).
Let us illustrate this with a simple example. Suppose the MWPL in a given stock ‘A’ is 1,000 contracts. When the aggregate open interest in the stock’s futures or options contracts touches 950, an F&O ban will be placed on it. At this time, when the ban is active, no new positions can be opened in the F&O segment of this stock. However, if you already have existing contracts, you can close your position or square it off.
Usually, this ban in the Indian financial market lasts for a single trading day. This can be extended if the stock breaks the MWPL again.
When Does a Stock Enter an F&O Ban?
Regulatory authorities like the stock exchange set certain criteria, such as a specified percentage increase in open interest, to find stocks that are predisposed to excessive manipulation. But before we talk about the ban, we must first understand the meaning of open interest and market-wide position limit (MWPL).
The market-wide position limit (MWPL) includes 20% of an enterprise’s total shares held by non-promoter entities. Let us assume that a company (X) has 100 shares, and non-promoter entities hold 60% of them, which is 60 shares. The market-wide position limit will be 20% of the 60 shares, which is 12 shares.
Open interest pertains to the overall number of outstanding derivative contracts like futures and options that are unsettled. When the total open interest of a particular stock exceeds 95% of the MWPL, the regulatory authority imposes an F&O ban.
Let us consider the above example. If the MWPL position for the company (X) is 12 shares, as per the regulatory authority’s rules, the open interest should not cross 95% of the 12 shares, which is 11.4 shares. If it does, the stock will be added to the F&O ban list. For the stock to be removed from this list, the open positions must fall below 80% of MWPL, after which traders are allowed to take new positions.
If any trader disobeys the ban and proceeds to create a new position in the stock, they will incur a penalty of 1% of the value of the increased position. This amount can range from Rs. 5,000 to Rs. 1 lakh.
Impact of F&O Ban on Share Price
As previously discussed, regulatory authorities ban specific stocks from the F&O trading list to control manipulative activity and volatility. If left unchecked, this can create instability, leading to negative investor sentiment across the market. But what happens when a stock is on the F&O ban list? The impact of the F&O ban depends on several factors, including the fundamentals of the given stock, the underlying cause of the ban, and market sentiment. The ban can affect the stock’s share price, as investors will be forced to square off their positions to minimise losses. The stock’s trading volume and liquidity also decrease because no new positions can be opened. The ban directly decreases the volatility in price and stabilises the stock price.
If the F&O ban has been imposed due to negative events or news about the business, the stock price will likely decline sharply as existing positions are sold off. In cases where the ban has been imposed because of excess fluctuations and the company fundamentals are strong, the price largely remains the same and can even experience a slight increase.
The impact of a ban can also have effects that last for different durations. Typically, the ban ends in a day, with the stock returning to regular trading the next business day. However, in some cases, the ban may be extended by the stock exchange if the stock’s price experiences continued volatility.
While the trade mostly takes place in the derivatives market, its implications can be felt even in the spot market. Thus, traders can incur massive losses if they aren’t vigilant.
The differing impact levels necessitate market monitoring on the part of traders and investors as enquiry into the nature and causes of the F&O ban can be useful in making strategic investment decisions.
Conclusion
It is important to remember that while trading in F&O, you must pay attention to even the minute details. Now that you understand what an F&O ban is, you can spot red flags. Additionally, the National Stock Exchange (NSE) updates the list of stocks in the F&O ban every day. It also offers a feature on its trading system to trigger an alert when the open interest in futures and contracts in security surpasses 60% of the specified MWPL for that security.
