Reimagining India’s Index Option Trading Framework

[Amritanshu Rath is a 3rd Year BA LLB (Hons) student at National Law University Odisha. Amani Pundir is an advocate practising in Delhi.]

Introduction

The derivative market in India experienced a radical change after the launch of stock options at the National Stock Exchange (NSE) in 2002. Since then, the Indian market has transformed into one of the world’s most active retail derivative markets, with more than 36.8 billion equity index options traded on India's NSE and Bombay Stock Exchange (BSE) in Q2 2024 alone, representing more than two-thirds of all futures and options traded globally.

With the increase in retail traders in the Indian derivative market came several problems associated with this growth. In modern option markets, there is high intraday trading, expiry-based strategies, fast hedging, and volatility. Sometimes, when an index is rapidly driven beyond the boundary of available strikes due to acute intraday volatility, the nearest available strike becomes distant from the prevailing price. This leaves traders unable to enter positions or execute hedges efficiently, impairing liquidity at the very moment it is most needed.

The scale of retail participation has made the infrastructure supporting options trading a matter of regulatory urgency. It is against this backdrop that, as a part of its “Ease of Doing Business” series, the Securities and Exchange Board of India (SEBI) recently released a Consultation Paper seeking an overhaul of the “Framework for strike prices of options contracts”. The Consultation Paper proposes a standardised framework across exchanges to govern the introduction and management of strike prices. One of the key proposals of the paper is the introduction of new strikes while the market is active during periods of heightened volatility.

In this piece, the authors analyse why availability of strike prices is a rising problem in volatile intraday trading, examine SEBI’s proposals, and then suggest a framework for addressing the strike price problem in India’s index options trading market.

Understanding Index Options and the Problem of Strike Availability

In the derivatives market, index options are contracts that give the buyer the right, but not the obligation, to buy or sell an underlying security in the future at a predetermined price, on or before a specified expiry date. These predetermined prices are known as the strike prices or exercise prices.

For call options, the strike price represents the price at which the underlying security can be bought, while for put options, it is the price at which the security can be sold. The strike price is a key variable of call and put options. On exchanges like NSE and BSE, trading liquidity in options contracts tends to concentrate around strike prices closest to the underlying index price, primarily due to convenience. Shaikh & Padhi (2014), in their study of NSE Nifty options, found that the liquidity of strikes is a key determinant of implied volatility patterns in the Indian options market, with near-the-money contracts consistently attracting the highest trading activity.

When a contract is launched, strikes are introduced across a range above and below the current index level. For instance, Nifty contracts have historically been introduced with 35 in-the-money (ITM) and 35 out-of-the-money (OTM) strikes at an interval of 50 points, while Bank Nifty contracts carry 45 ITM and 45 OTM strikes, covering roughly 7 to 8 percent of index movement around the prevailing price at the time of introduction.

This indicates that although the preset strike range is quite wide, it is pegged on average market situations. In case of sessions full of events, like an RBI policy announcement or risk-off situation around the world, the index may be above or below the strike range after some hours, thereby making the outer strikes irrelevant.

In the case of a strong movement of the underlying index throughout the day, the time aspect of the suitability of the strike is highly significant; that is, the near-the-money strike from just some moments ago could be far OTM or ITM.

The Problem: Strike Range Inadequacy During Sharp Intraday Moves

While the strike range definition proves to be effective under usual market circumstances, it might fail to work properly under abnormal conditions. In situations where the index moves rapidly and significantly, it could breach the last defined strike, resulting in a gap between the prevailing market price and the closest strike price. While the available strikes continue to trade, there is no defined new strike that is close enough to the existing index value to use for practical purposes.

Imagine a trader who has taken a long position on the Nifty futures contract and wishes to buy a put option in order to protect himself from a sharp decline. The Nifty Index falls by 400 points, and the closest strike for the put available is 300 points above the current index level. This means that the trader will use an inefficient protection strategy since the delta of a deep ITM put is different from the delta of a near ATM put. The absence of a nearby strike does not technically prevent new positions, but it forces market participants into commercially inappropriate contracts.

Moreover, there is currently no unified approach for dealing with strike intervals as each exchange tends to implement its own strategy and leaves room for inconsistency between NSE and BSE where there is no obligation to introduce new strikes during trading sessions. The problem is further compounded by the fact that exchanges currently follow different mechanisms for managing strike intervals, creating inconsistency across NSE and BSE with no standardised obligation to introduce new strikes intraday as the market moves. SEBI has observed in the Consultation Paper that strike intervals have a direct bearing on trading activity and product availability for market participants, and it is this regulatory gap that the Consultation Paper seeks to address through a structured, exchange-level framework for dynamic strike management during live market hours.

SEBI's Proposed Framework for Strike Price Management

The proposed framework of SEBI for the introduction and management of strike prices is exchange-oriented. In general terms, it involves exchanges creating rules which will cover three main responsibilities.

The first requirement under the Consultation Paper would be ensuring that a minimum number of in-the-money and out-of-the-money contacts are available when an option series is introduced. The second requirement will involve carrying out a check on a daily basis whether strikes are available close to the market price. And thirdly, there will be periodic deletion of strikes that have diverged far away from the market price.

One important element of the SEBI framework is creating an exchange capability of introducing new strike prices in real-time during live market hours according to the price movement of the underlying security, without any change in the broker’s side system requirements. This will solve the problem of unavailability of strikes midway through the session.

Comparative Perspectives

The challenge of maintaining continuous strike availability during periods of sharp intraday movement is not unique to India. Major derivatives exchanges globally have developed varying structural responses to the problem, offering comparative perspectives that Indian regulators can take note of.

The Chicago-based CME Group, which operates various financial derivatives exchanges, including the Chicago Mercantile Exchange, the New York Mercantile Exchange, and the Commodity Exchange, governs strike prices by predefined listing rules that respond dynamically to underlying price movement. As the underlying futures contract moves, the exchange monitors and adjusts the range of available strike prices. This helps in expanding coverage when prices trade beyond previously listed boundaries. It also introduced a reduction of the number of strikes in our options offering to increase the “focus of liquidity provision while providing a more relevant array of strikes”.

Cboe, the world's largest options exchange by notional value, adopts a dynamic system for strike prices. Rule 4.1.3 of its Rulebook (Page 144) provides that in the event that the underlying index has moved in such a way that there are no available series that are at least 10% below or above the current value of the underlying index, the Exchange may list additional prices. Additionally, the Rulebook also stipulates that any strike prices listed by the Exchange shall be within 30% above or below the current value of the underlying index (Page 156).

Drawing from these dynamic, trigger-based approaches, the authors suggest the following framework to address the issues raised by SEBI in the Consultation Paper.

An Effective Framework for Flexible Strike Prices

At this stage, SEBI’s proposals appear more of a direction to stock exchanges to frame their own rules on strike intervals, the minimum ITM and OTM contracts, the addition of new strikes and the removal of the outdated ones. While such flexibility may allow exchanges to tailor their systems according to liquidity and segment-specific considerations, excessive discretion may also result in inconsistent approaches across exchanges. Inconsistency, which will ultimately put investors at a disadvantage.

To address this, the authors propose a three-fold uniform framework that should be adopted by stock exchanges across the country in an effort to make India’s index option trading framework more efficient.

Firstly, Indian exchanges should adopt a predefined percentage-based trigger mechanism linked to the movement of the underlying index toward the outermost available strike. Where the current index prices approach within a specified percentage of the last listed strike, an automatic trigger should activate the next set of pre-loaded reserve strikes (discussed below). To prevent excessive proliferation, exchanges should specify a maximum number of trigger activations per session. If that cap is reached, the exchange should notify participants and invoke a manual review rather than continuing automatic activation.

Secondly, exchanges should maintain a tiered strike pool. Let us consider three sets of strikes. “Set A” includes the currently available strike prices. “Set B” is a secondary layer of dormant but pre-loaded strikes. It will activate automatically upon the Set A trigger being activated, becoming immediately tradable without requiring broker-side system changes during live market hours. Following the activation of Set B, a new set of strike prices, “Set C”, shall become the new dormant reserve pool. This will ensure continued strike availability even if volatility persists. This layered structure with built-in triggers also addresses SEBI’s concern that there be no changes in the systems of the stock brokers or market participants during live market operations.

Exchange systems must also prevent potential risks that arise due to automated activations, such as faulty data feeds and wrong triggering mechanisms, by conducting prior testing and live monitoring.

Lastly, strikes that have moved significantly away from prevailing market levels and demonstrate negligible trading activity should be subject to periodic rationalisation. Indian regulators can take note from the Cboe’s 30% threshold for rationalising far strike prices.

Conclusion

India's index options market has grown faster than the frameworks meant to support it. The problem of strike unavailability during sharp intraday volatility is not just a technical inconvenience. It is a market integrity issue that directly impairs hedging efficiency, widens effective spreads, and puts retail participants at a disadvantage when they can least afford it.

The Consultation Paper released by SEBI is indeed welcome, but allowing the exchange wide discretion may result in the same set of problems the regulation intends to address. A system where both NSE and BSE have their own ways of managing the strikes does not serve the interest of the trader, as well as the overall objective of establishing a robust derivatives market. The three-pronged approach suggested in this paper is based on good practices followed internationally as well as the actual scenario in India. Together, a percentage-based trigger system, an incremental preloaded strikes list and a regular threshold for rationalisation would result in the availability of strikes where and when needed, without disturbing the trading systems of the brokers.

India is no doubt one of the busiest retail derivatives markets in the world at present. The regulatory framework that governs it needs to reflect its position. A standardised strike price system is not just a procedural issue; it is a structural requirement for the market to move ahead towards maturity.