When the tail wags the dog: Understanding Futures and Options
Introduction
The National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) offer various segments for investing and trading, including capital markets, equities, futures and options, currencies, and commodities. In this article, we will explore the world of Futures and Options (F&O) trading, its concerns, and potential curbs to rein in the frenzy.
The Rise in Options Volumes and Sebi’s Concern
Despite facing significant losses, retail investors have shown immense interest in Futures and Options trading. The average daily turnover (ADT) of F&O has surged 34.5 times from FY19-24, while cash volumes have only doubled. This exponential growth has raised concerns among market regulators, particularly the chairperson of the Securities and Exchange Board of India (Sebi). As a result, brokers anticipate the implementation of stricter measures to control the situation.
Understanding the F&O Segment
The F&O segment provided by NSE and BSE enables market participants to invest and trade in a variety of instruments, including equities, futures and options, currencies, and commodities. While the capital markets and cash segments allow investors to buy and sell shares directly, the derivatives segment, such as F&O, provides an avenue for hedging and speculative trading. In this segment, participants are required to deposit only a fraction of the total amount needed to trade shares. Over the past three years, retail investors have shown a strong inclination towards relatively affordable index options, particularly those based on Nifty and Bank Nifty.
Concerns Surrounding F&O Trading
The rise in options volumes has raised alarm bells for Sebi. Despite extensive research showing that nine out of ten investors lose money trading options, the ADT of F&O, primarily driven by options trading, has skyrocketed while cash volumes have shown a modest increase. The popularity of F&O trading, especially in weekly index options, has grown rapidly. Retail investors often lack the expertise and tools necessary for successful trading, unlike better-informed proprietary traders who rely on algorithms.
Potential Curbs to Control the Frenzy
Although it is challenging to restrict participation in F&O trading outright, regulators can impose higher margins and minimum net worth criteria. Currently, options buyers pay significantly less than futures buyers. For example, a weekly 19,900-call options contract costs only ₹872, compared to over a lakh for a Nifty futures contract. Increasing margins could lead to higher costs for buyers, potentially discouraging excessive risk-taking.
Existing Curbs and Risk Disclosures
Currently, the only existing curb in F&O trading is the mandatory risk disclosure. Before proceeding with trading, clients must acknowledge the risk disclosures mandated by Sebi. These disclosures highlight that nine out of ten individual traders in the equities futures and options segment incur net losses, with an average loss of ₹50,000. Additionally, traders who experience losses incur an additional 28% of net trading losses as transaction costs. On the other hand, those making net trading profits incur transaction costs ranging from 15% to 50% of their profits.
Effectiveness of Risk Disclosures
Despite the introduction of risk disclosures, the spike in F&O turnover suggests that they have had minimal impact. Data reveals that the notional turnover (market value) of F&O in the current fiscal year (FY24) has surpassed the previous year’s turnover. From April to November, the total turnover stands at ₹45,452 trillion, representing a 19% increase from FY23’s ₹38,223 trillion. Index options account for 98.5% of the total turnover. It is worth noting that the surge in turnover coincides with the countrywide lockdown due to the COVID-19 pandemic and a 12% rise in the Nifty index to 19,812.
Conclusion
The surge in F&O trading, particularly in options volumes, has raised concerns within the Securities and Exchange Board of India (Sebi). Despite the high risk and average losses faced by retail investors, their interest in F&O trading continues to grow. To address this issue, potential curbs such as increased margins and minimum net worth requirements are being considered. However, the effectiveness of these measures remains to be seen as the turnover in F&O trading continues to rise.
Disclaimer:
Estabizz Fintech compiled the material in this article using the most recent Acts, Rules, Circulars, Notifications, Provisions, Press Releases, and material applicable at the time. They ensured the completeness and correctness of the material through due diligence. When using this material, users must consult the relevant, applicable legislation. The given data may change without prior notice and does not constitute professional advice. Estabizz Fintech disclaims all liability for any results from the use of this material.
