HONG KONG: HKEX Consultation on Revision of Stock Option Position Limit Model

Friday April 8 2016

Hong Kong Exchange and Clearing Ltd has published a consultation paper on the revision of the Stock Option Position Limit Model.

After the revision of the Securities and Futures Ordinance (SFO) in 2006, the statutory stock option position limit was increased from 5,000/25,000 open contracts to 50,000 open contracts in any one market direction for each stock option class and in respect of all expiry months. HKEX’s trading rules prescribe the maximum stock option positions that Exchange Participants (EPs) and their clients can hold, but under Hong Kong’s existing regime, the exchange-imposed position limit cannot exceed the statutory position limit.

The following issues were identified after a review of HKEX’s existing stock option position limit model:

• Currently, HKEX adopts a formulaic and two-tier approach when setting its position limit for stock options, taking into account the market capitalisation and liquidity of the underlying stocks. Under this approach, certain stock options are assigned a position limit of 50,000 contracts and others are assigned a position limit of 30,000 contracts. Due to the low threshold fixed by the statutory limit, HKEX has assigned the same position limit of 50,000 contracts to 80 of its 84 stock option classes in order to allow the market to have maximum flexibility. This means that although the Exchange uses a two-tier model, the entire market effectively operates under a single position limit of 50,000 contracts with no real differentiation as to the market price, board lot size and market capitalisation of the underlying stocks.
• Hong Kong’s existing position limit regime does not have a regular review mechanism to cater for material changes in the characteristics of the underlying stock. There is also no regular review to cater for changes due to market development, and there is no mechanism for adjustments due to corporate actions that have an impact on the underlying stock. As a result, the effectiveness of stock options as a hedging tool may be affected.

Based on feedback from a previous soft consultation and a comparison with overseas markets, HKEX has proposed a three-tier model for its stock option position limit. Under the model, HKEX’s position limit is set by reference to the contract size along with the number of outstanding shares and turnover of the underlying stocks. The three-tier model’s position limit is 150,000/100,000/50,000 open contracts in any one market direction for all expiry months combined.

The position limit under the three-tier system is 50,000, 100,000 or 150,000 contracts. If the contract-equivalent number is equal to or higher than 150,000 contracts, the position limit would be set at 150,000 contracts. If the contract-equivalent number is equal to or higher than 100,000 but lower than 150,000 contracts, the position limit would be set at 100,000 contracts. If the contract-equivalent number is lower than 100,000 contracts, the position limit would be set at 50,000 contracts. The tiers are illustrated in the following table.

*On the basis of existing practice: the number of open contracts per option class in any one market direction for all expiry months combined

The contract-equivalent number is calculated based on the number of outstanding shares and turnover of the underlying stocks. It is determined by the followings: 5 per cent of the outstanding shares, provided that it is not:

• lower than 25 per cent of the stock’s turnover for the past six months;
• higher than 33 per cent of the stock’s turnover for the past six months.

Otherwise, if 5 per cent of outstanding shares is lower than the 25 per cent threshold, the contract-equivalent number is set at the 25 per cent of the stock’s turnover for the past six months; or if 5 per cent of outstanding shares is higher than the 33 per cent threshold, the contract-equivalent number is set at the 33 per cent of the stock’s turnover for the past six months.

The rationale for the 25 per cent threshold is to cater for underlying stocks with above average trading. In those cases, 25 per cent of the past six months’ turnover of the stock will be used to determine the position limit.

For underlying stocks with below average trading, setting the position limit at 5 per cent of outstanding shares might be too large from the liquidity perspective. If so, the limit will be set at 33 per cent the stock’s turnover in the past six months.

Prudence Measures

In practice, the contract-equivalent number for some stock options with a small contract size might be well beyond the tier 1 position limit level of 150,000 contracts. As a result, 150,000 contracts is the top level in the proposed model, with a view toward a conservative start if changes are made.

The calculation of the contract-equivalent number is subject to an additional liquidity threshold at 6.7 per cent of the past six months’ turnover of the underlying stock if the model is adopted. This is to ensure a smooth transition and prevent speculative positions concentrated in any single expiry month from having an impact on liquidity. The liquidity threshold could be revised from time to time as deemed appropriate by HKEX.

Examples of the calculation of the stock option position limit under the proposed model are shown in the table below.

The proposed model includes regular reviews. They will be conducted at the end of each November, and the results will be announced in the following December. If revisions are necessary, they will take effect on 1 April of the following year to provide a buffer for investors to unwind any excess positions.

Click on the link above for further information.