Indian stock markets have been making headlines regularly, not just for the eye-popping returns but also for the hysteric pace at which trading activity has been increasing in recent years.
The number of equity futures and options contracts traded on NSE (where most of equity derivative trading happens) has been growing exponentially, from 513 crore contracts in FY20 to 4176 crore contracts in FY24. In other words, activity has been doubling almost every year since the pandemic.
Increase in turnover is not really a bad thing, if the derivative market supports the cash market in better price discovery and allows investors to hedge their risks. The concern is that the rising volumes are driven mostly by speculative activity, with volume concentrated in 3 to 4 index options. Almost 98 per cent of equity futures and options trading on the NSE is limited to just Nifty50, BankNifty and FinNifty options. Other stock options, stock and index futures are evincing meagre interest.
The increasing participation of retail investors in these index options has also raised the red flag among regulators. The SEBI consultation paper on ‘measures to strengthen the index derivative framework for increased investor protection and market stability’ points out that retail investors are flocking to derivative products such as weekly index options where they can trade with small initial outlay. Most trading in these products takes place in the final hours of the expiry day.
The paper has some sound proposals to address the frenetic activity in index options. But besides these proposals, stock exchanges and stockbrokers should also be told to detect and arrest such excesses instead of stoking them, in a bid to grow volumes.
Weekly derivative contracts
The working group constituted by SEBI to review derivative trading norms, headed by G Padmanabhan, has rightly zeroed in on the concentration of equity derivative activity in index options. The influx of individual investors, which began during the pandemic, continued even after the people went back to their offices. This has been due to tweaks made in weekly index options by the exchanges.
Equity derivative contracts typically have a tenure of one month. But the NSE introduced weekly options contract in 2016 on Bank Nifty and in February 2019, weekly contracts on Nifty50 were introduced.
Now, till 2022, all the weekly contracts expired on the same day of the week. But from 2022, different contracts began expiring on different days.
The SEBI paper notes that the exchanges have been shuffling the expiry dates in such a way that there is a weekly index derivative contract expiring on every day of the week.
How does this affect trading? The SEBI paper notes that 97 per cent of the bankex contracts’ 5-day volume and 96 per cent of weekly Sensex contracts’ 5-day volume takes place on the expiry day. Further, the trading activity is concentrated in the last 30 minutes on the expiry day.
This is because the option premiums tend to reduce as the expiry draws close. So, traders pay less to buy options on the expiry day, especially in the final hours of the expiry day. Though this is a risky proposition, trading activity is being concentrated in weekly option contracts, which expire on the day.
Behaviour of individual investors
The trouble is that individual investors are the most active in these weekly index options. The SEBI paper shows that they have increased the share of their trading in index options from 2 per cent in FY18 to 41 per cent FY24. The increase in trading in options seems to have been propelled by the introduction of weekly option contracts by the exchanges.
Of concern is that most of these individual traders are making losses. In FY24, 92.5 lakh individuals and proprietary firms traded in stock markets and incurred a cumulative loss of ₹51,689 crore. Beyond the trading loss, another 23 per cent was spent by traders on transaction costs. On the other hand, large institutional players, including foreign portfolio investors using trading algos have been making offsetting profits.
Some may argue that India is a democratic country and people have the right to burn their money at the bourses if they wished to. While that is true, such unbridled speculation, which plays no part in capital creation, erodes the credibility of Indian stock market. A vibrant derivative market should have volume distributed across instruments to help hedgers.
Measures proposed
The paper is proposing some sound measures based on analysis of trading patterns in the weekly index derivative contracts, to curb the speculative excesses. The most publicised is the proposal to increase contract sizes from the current ₹5 to 10 lakh to ₹20 to ₹30 lakh, in phases. This is good as it will make individual traders cut down the trading activity.
But two other suggestions — to collect upfront margins from option buyers and to implement intraday monitoring of position limits — are also very critical to check the runaway speculation in index options. The allowance given to option buyers to not to pay margins upfront is providing them leverage to trade without initial outlay and leading to the migration of volumes to index options. With position limits being checked only towards the end of the day now, traders can go far beyond their limits intraday.
Measures such as reducing the number of strike prices in a contract to 50 and increasing the extreme loss margin on the day of the expiry and on the previous days could help arrest the activity around the expiry time of weekly index options.
The proposal to limit weekly derivative contracts to a single benchmark index of an exchange is good as it prevents intense speculation on all days of the week. But given that monthly options are enough for hedging purpose, it is moot whether weekly options are needed at all.
Warning to exchange, brokers
The role played by market intermediaries such as stockbrokers in stoking such speculative activity can not be ignored. Practices such as brokers asking clients to trade derivatives by offering them leverage, stockbrokers trading on behalf of their clients in derivative markets and mis-selling derivatives to investors as high return investment products are rampant. A warning against such practices would help. Similarly, stock exchanges also need to be told to stop chasing turnover growth by introducing products such as weekly options on all days. They ought to have spotted the risk being taken by individual traders in this space and taken corrective action.