The stock market regulator, Sebi, has issued yet another warning about a dangerous investing trend: futures and options (F&O) trading. Every day, Indians lose large sums of money, up to Rs 60,000 crore per year, by gambling on F&O contracts. The Sebi chief Puri Buch claims that this is a severe issue that might harm the economy as a whole.
Buch further explaned stating, "If Rs 50,000-60,000 crore a year is going away into losses in F&O whereas that would have been productively deployed as may be the next IPO round, maybe MF, to other productive purposes, why is that not a macro issue?"
What exactly are financial and operational contracts?
Assume you believe a stock price will rise. You can buy the stock directly, but F&O contracts provide a riskier alternative to play. They are essentially agreements to purchase or sell a stock at a set price by a specified date.
Why are they risky?
Most F&O bets (about 90%) result in losses! Unlike purchasing and keeping a stock, F&O contracts have a deadline. If your guess is incorrect by that date, you will forfeit your money."Unlike stocks, whose price movement is more simple, F&O pricing is complicated and depends on a number of variables, including the stock's volatility, time till expiry, strike price, discount rate, and current stock price. Furthermore, F&O pricing is frequently influenced not just by fundamentals, but also by market excitement and knee-jerk reactions. External factors such as market emotion, speculation, and unexpected market reactions can all contribute to illogical price volatility in the derivatives market, more so than in the stock market," stated Piyush Syal of Value Research.
Unscrupulous Business Model
According to Value Research, derivatives are the lifeblood of brokers, making up an important part of their business strategy.
The industry's principal purpose is to increase derivatives trading volume, with members aggressively directing clients to F&O.
"On popular online brokerage platforms, a fixed fee of Rs 20 is often charged for each performed derivative deal. Equity trades incur no brokerage fees. This demonstrates that brokers' income is inextricably related to the total amount of derivatives trading.Furthermore, SEBI's report states that transaction cost as a percentage of overall net trading profit was 15% in FY22, whereas transaction cost as a percentage of total net trading loss produced by loss makers was 23% in FY22. This demonstrates that frequent trading resulted in greater transaction costs," explained Syal.
What is Sebi doing about this?
The Sebi is proposing new restrictions to make F&O trading less appealing to retail investors. This includes:
1. Limiting the amount of F&O contracts that can expire every week.
2. Raising the minimum amount required to invest in F&O contracts.
3. Requiring investors to pay the whole price of the option up front, rather than just the deposit.
In recent years, stock market involvement in India has increased significantly. According to data from the Association of Mutual Funds in India, investments under the SIP method (systematic investment plan) totaled Rs 1.99 lakh crore in 2023-24, more than doubling from Rs 92,693 crore in 2018-19. However, there are worries about the fast increase in futures and options (F&O) trading among ordinary investors.
Earlier this year, the Sebi recommended a number of steps to combat speculative trading, such as gambling in index derivatives, including limiting multiple option contract expiries and raising option contract size.
An previous Sebi investigation found that 90% of trades resulted in losses. On Tuesday, the capital markets regulator issued a consultation document recommending methods to curtail activity.
The spike in retail involvement in the futures market has corresponded with a considerable increase in revenue, from Rs 4.5 lakh crore in 2018 to Rs 140 lakh crore by 2024. However, this development has been accompanied by a significant increase in losses, with 90% of traders reporting negative returns.
Sebi proposes many steps to reduce excessive speculation. These include raising the size of F&O contracts, decreasing the frequency of contract expiry, and requiring upfront payment of option premiums. The regulator is also looking into stronger standards for investment advisors and methods to make the Application Supported by Blocked Amount (ASBA) system mandatory for all authorized brokers.
Currently, index-based contracts have a daily expiration. The Sebi is contemplating permitting only one weekly contract per index to prevent short-term speculation. To prevent small investors from high-risk transactions, the Sebi has recommended increasing the minimum contract size from Rs 5-10 lakh to Rs 15-20 lakh in the first phase, and then to Rs 20-30 lakh later. Sebi also intends to limit undue leverage by requiring investors to pay the entire option price upfront, as opposed to the existing practice of blocking collateral.
According to the research, "Option prices based on moneyness move in a non-linear manner and thus carry very high implicit leverage." These are timed contracts with the prospect of rapid price growth and depreciation. To minimize any undue intraday leverage to the end client and to discourage any market-wide practice of permitting positions beyond the collateral at the end client level, the TM/CM should receive the options premium upfront from the options buyer.(Currently, CCs ban collateral at the CM level for option purchase deals).
Sebi is also targeting a specific sort of hazardous F&O transaction popular among individual investors: low-cost options contracts with strike prices that are distant from the current market price. These are sometimes referred to as "out-of-the-money" options due to their minimal likelihood of being successful.
Sebi has recommended a system with tighter intervals for striking prices close to the current market price (around 4% higher or lower). As strike prices move further away (becoming more "out-of-the-money"), the intervals will broaden (between 4% and 8%). This makes it less appealing to risk on choices with a low probability of success.
At launch, exchanges will be limited to provide no more than 50 strike prices for a single index derivatives contract. This reduces the quantity of "out-of-the-money" alternatives available, making it more difficult for investors to pursue unusual bets. The Sebi wants all stock exchanges to adopt these rules in a coordinated way to guarantee a fair playing field and prevent any exchange from offering a broader choice of hazardous alternatives to entice investors.
What will happen if these steps are implemented?
According to Motilal Oswal Financial Services, "If the measures are implemented in the final rules, volumes are expected to be impacted for both retail participation (upfront premium collection and increased lot size) and HNIs/High Frequency Traders (removal of calendar spread advantage and extra margin for expiry). Price increases might help brokers mitigate the damage."
