In a recent event at BSE, the Finance Minister brought up the elephant in the room by warning that “unchecked explosion” in retail trading in futures and options (F&O) could create challenges for the market and investor sentiment. She said that it was necessary to safeguard household finances from being “shattered” by this trend.
Government officials usually pay scant attention to happenings in the derivatives market, which has only the slimmest connection to the real world and the economy. But developments in India’s equity derivatives market since Covid do suggest that something is ready to shatter soon.
Retail losses
As election jitters prompted India’s bellwether indices to mildly dip by 4 per cent this month, it was not institutions or HNIs investing billions who were fretting about losses. Instead, the social media was flooded with retail investors complaining about losing their shirts at options trading.
One trader shared that he had lost ₹80 lakh while he was in the gym, after a sharp move took up the index put option premium from ₹50 to ₹1,000. Others complained of ‘injection’ moves in the Sensex and Midcap Nifty options which wiped out their accounts.
Meanwhile, Bloomberg reported an interesting titbit about a courtroom drama in the US, where Jane Street, a quantitative trading firm, had sued Millennium Management, one of the world’s largest hedge funds. Jane Street was accusing Millennium of luring away two of its employees who were running a lucrative options trading strategy that made $1 billion in profits. The strategy involved ‘exploiting inefficiencies’ in the Indian options market.
This news led to dark mutterings about Indian retail investors being exploited by foreign hedge funds and high-frequency traders, with calls for regulators to ‘do something’ about it.
Caveat investor
It is really difficult to see what regulators can do to protect retail folk from the consequences of their own fool-hardy risk-taking in F&O.
Post-Covid, SEBI has tried out many initiatives to discourage retail investors from making a beeline for F&O. To put a stop to them taking on unlimited leverage, it tightened margin norms and imposed hard limits on the leverage traders could avail. To make them aware of risks, brokers were asked to share elaborate risk disclosure documents with all investors signing up for F&O.
When this didn’t work, in January 2023, SEBI published a research study capturing real-life data on how retail traders were getting pummelled in derivatives. It showed that 9 out of every 10 retail F&O traders made losses, with the losses averaging ₹1.1 lakh. Transaction costs added 28 per cent to these losses.
This study has since been mandatorily plastered on the opening page of every F&O trading platform, so that the trader sees it every time he logs in.
Growing faster than cash
But all this has not deterred newbie traders from jumping into the F&O market like lemmings off a cliff.
In FY19, the NSE had 75 lakh active retail investors in the cash market and 12 lakh individual F&O traders. By FY24, the number of F&O traders had grown by eight times to 96 lakh, while cash market investors rose only four-fold to 307 lakh.
In the last two years, despite SEBI warnings, the number of individuals punting on F&O has risen from 51 lakh to 96 lakh. The turnover contributed by individual investors in NSE’s equity derivatives segment in FY24, at ₹213-lakh crore (based on premiums) easily dwarfed their cash market turnover of ₹131-lakh crore.
There’s therefore good reason to believe that household savings that could be better deployed in buying and holding other productive assets, is being deployed in F&O.
Sharks versus minnows
Seasoned traders also point out that newbies are crowding into the riskiest segments of the F&O market, in their eagerness for multi-bagger returns.
Retail bets are concentrated in weekly index (particularly Bank Nifty) options, where intra-day volatility and high leverage can multiply or decimate capital within a single session. Not content with this, some are exploring Midcap Nifty and Fin Nifty options, which are prone to even more stomach-churning moves due to illiquidity.
Impatient with holding options for a week to a month, many retail traders jump daily from one instrument to another chasing expiries, hoping to ride “zero-to-hero” moves in option premia before they vanish. In the last six months, the one-way move in the market has also prompted retail traders to get into naked put writing, a trade that exposes them to unlimited losses if markets fall.
The above ‘strategies’ are abetted by the stock exchanges. They have rolled out options contracts on their most volatile benchmarks and set expiries for different contracts on different days, so that retail folk are not deprived of their daily fix of suicidal trades.
This being the state of affairs, it is hardly surprising that the global sharks of short-term trading, armed with algorithms and co-located facilities that can trade massive volumes in nano-seconds, are making a meal of the minnows in the Indian market. If global funds were not on the scene, these newbie investors would still fall prey to local brokers or proprietary traders who know their way around F&O much better than them.
De-addiction strategies
Mounting losses though, do not seem to be deterring retail traders from chasing after F&O. Therefore, SEBI may need to de-addict them by taking away the instruments that facilitate irrational punts.
Get in DIIs: The real purpose of the derivatives market is to allow investors in the physical market for an asset to hedge against adverse price moves. Today, domestic institutional investors (DIIs) such as mutual funds, insurers, pension funds and the Employees Provident Fund hold about ₹61-lakh crore worth of equities (as of March 2024). Yet, they have hardly any presence in the F&O market. Getting DIIs to actively use derivatives to hedge against volatility and event risks could lead to a more rational F&O market, apart from helping the investors in their schemes.
Devise better instruments: To facilitate hedging, F&O contracts need to be available on indices backed by significant real-life investments. It is strange that narrow indices such as the Bank Nifty, Fin Nifty and Midcap Select Nifty which have hardly any funds benchmarked to them, have active F&O contracts, while widely used indices such as the Nifty Midcap 150, Nifty100 or BSE 500 have none. F&O contracts must be made available on the benchmarks that are widely used by institutions or backed by passive assets. This can help DIIs and long-term investors use F&O to create hedges for investments they actually own.
Streamline expiries: For investors to take a directional view on the market or buy a portfolio hedge, F&O contracts with long tenors are critical. Contracts with weekly expiries hardly serve this purpose and must be done away with. Contracts offered by the exchanges must be streamlined so that expiries are harmonised to a single day in a month and expiry-day trades take a back seat.
Measures such as these are sure to shrink the record trading volumes being logged by Indian exchanges. They will also work against commercial interests of the exchanges, brokers and the stock market ecosystem who have been feeding off the retail F&O frenzy. But all this seems necessary to de-addict retail investors from their F&O fetish and secure the long-term health of India’s capital markets.
Despite SEBI doing its best, retail investors can’t seem to keep away from the risky F&O segment. Getting more DII presence and devising better instruments could help