Impact of F&O ban on stock prices

Trading in the futures and options (F&O) segment is highly risky, especially for small and retail traders. Thus, the market regulator Securities & Exchange Board of India (SEBI) and institutions like stock exchanges have formulated and use several tools to manage risk in the market. One such tool is the F&O ban.

Every security traded in the F&O segment is subject to a trading limit called the market-wide position limit (MWPL). A market-wide position limit is expressed in the number of shares. Simply speaking, it is lower of

• 30 times the average number of shares traded daily during the previous calendar month in the cash segment; or,
• 20% of the number of shares held by non-promoters (sometimes also called free float shares)

Market-wide positions limit is calculated for every month. For instance, check out the market-wide positions limit for some stocks in the month of February 2023:

Stocks or securities go under a ban period when the open interest across exchanges in the security reaches 95 percent of market wide position limit. Usually, exchanges disseminate the open interest for all securities at the end of the day. 

Open interest is the total number of outstanding contracts in the derivatives segment, and it reflects the number of traders who have either bought or sold the contracts.

At the end of every day, exchanges test whether the aggregate open interest for any scrip exceeds 95% of the market wide position limit for that scrip. If yes, the exchange takes note of open positions and from the next day onwards bans the creation of any new position in the security.

At the end of every trading day, exchanges publish the list of securities entering the ban period.

What happens when stocks go under F&O ban?

When a stock is placed under the F&O ban, traders are barred from taking any fresh position in the stock. Traders can only decrease their positions by unwinding their positions till normal trading in the scrip is resumed.

The normal trading in the scrip is resumed only after the aggregate open interest across exchanges i.e market wide position limit comes down to 80% or below.

F&O ban does not mean that trading in that stock is banned – traders are allowed to unwind their position. In fact, the aim of this tool is to make sure froth is eliminated. It is simply a temporary measure to alleviate the volatility in a counter.

Why F&O ban?

When the open interest in a stock’s derivatives contracts exceeds the prescribed limit, it can lead to market manipulation, price distortion, and systemic risks, which can be detrimental to the functioning of the derivatives market. In such a situation, futures and options stop being price discovery tools & simply become a means of speculation. Securities are placed under a ban to discourage such behaviour.

Savvy traders keep an eye on market wide position limits of stocks they are trading in and avoid trading in stocks that are frequently placed under the F&O ban.

If a stock is placed under the F&O ban, it usually means a trader may have to square off his or her position at an unfavourable price. They also may have to cut down their potential profit or even book losses. This happens because price movement in the underlying stock continues and if the price continues moving in an unfavourable direction and you are not allowed to take fresh positions, it is not good news as the trader is stuck with an open position.

Impact on stock price

An F&O ban may sap the demand for a security, especially in the derivatives market. Since the price of any security is a function of supply and demand, when demand falls supply increases. This leads to a deterioration in the price of the security.

Thus, when a stock is placed under the F&O ban, usually stock price corrects or falls.

How to track market wide position?

There are several third-party tools and apps that display market wide positions on F&O stocks. Most brokers also have a separate window for this.

The National Stock Exchange (NSE) also provides a facility on the trading system to display an alert once the open interest on the NSE in the futures and options contract in a security exceeds 60% of the market wide position limit specified for such security. Such alerts are presently displayed at time intervals of 10 minutes.

FAQs

Does the F&O ban apply to indices?

No, the F&O ban does not apply to market indices. Traders who trade in index futures and options contracts are unaffected by the F&O ban.

When does the F&O get out of the ban?

The F&O ban is reversed when the aggregate open interest across exchanges i.e market wide position limit comes down to 80% or below.

What are typical stocks which would land in this ban?

Stocks or securities go under a ban when the open interest across exchanges in the security reaches 95 percent of market wide position limit. Hence, stocks that have a high degree of volatility, speculative interest, or are in news for any reason, are more likely to be in F&O ban list.

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