Frenzy In F&O Trading And SEBI

Warrant Buffet in his 2002 chairman's letter for his holding company Berkshire Hathaway, while referring to derivatives, wrote, "We view them as time bombs, both for the parties that deal in them and the economic system". He further added in the same letter that, "derivatives are financial weapons of mass destructions, carrying dangers that, while now latent, are potentially lethal."

Exchange traded derivatives are standardised contracts regulated by stock exchanges under the overall superintendence of securities market regulator. Trading in futures and options (F&O) in India (equity derivatives) has seen a sharp growth since Covid-19 lockdown in 2020. Lockdown led to flock of new savvy traders trying to make a quick buck in the stock market. Options trading was taken up as a side hustle, as many individuals started working from home during lockdown. There have been instances were these individuals (salaried or already engaged in some other full-time business) would have separate laptops for office work and F&O trading for punching trades while working from home. During Covid-19 lockdown, the financial savings were high and there were no other avenues to spend.

Indian stock market suddenly discovered these new young investors who entered during Covid-19 lockdown attracted towards F&O trading. After the crash in March 2020 because of the Covid-19 lockdown, stock market indices in India witnessed an unprecedented one-way rally which took the Nifty 50 Index from the low of around 7,500 in March 2020 to a high of around 18,604 in October 2021, being a jump of more than 100% in absolute terms. Perhaps, no other asset class witnessed such a mind-boggling rally and that too at an index level.

Coinciding with this was also an unprecedented addition in the number of demat accounts, coupled with easier KYC norms, cheap mobile data and easier availability/affordability of smartphones.

It is said that, once in a while, youthful stupidity is a better way to find happiness than making choices which are mature when you grow older. You may have read about how working professionals who were drawn to the idea of accelerated returns through F&O trading, only to later realise that, F&O trading can also lead to losing the capital completely. Apparently, there is an underlying assumption that, F&O trading promises quick riches, but the dreams are shattered when they realise that addiction to trading can fuel a cycle of relentless losses.

While the broad risks involved in F&O are well-known, it's worth repeating some of them:

1. Buying options can result in losing the entire premium paid, but selling options can lead to even greater losses than the initial margin, if the price does not move as anticipated prior to entering the trade.
2. Orders can be executed partially or at a significant price differences due to volatility and liquidity.
3. Higher impact cost.
4. Higher leverage which may result in wiping out the initial margin paid upfront.
5. Shortfall in margin, if margin requirement goes up.

The Securities and Exchange Board of India ("SEBI") studied the profit and loss of individual traders dealing in equity F&O segment. Period of SEBI study was specifically FY19 and FY22, to study the influx of individual investors before and after the lockdown. Following were some of the findings of the report (25 January 2023) across all products in equity F&O segment:

1. During FY22, Individual traders belonging to age group 30-40 years had the highest share in participation (39%) across all age groups. For younger individual traders (20-30 years), the percentage share of participation went up significantly from 11% during FY19 to 36% during FY22.
2. The trading by individual traders in equity F&O segment were dominated by males (>80%) during both the years.
3. 89% of the individual traders(i.e. 9 out of 10 individual traders) in equity F&O segment incurred losses. During FY22, 11% of individual traders in equity F&O segment made profit.
4. Among all the unique individual traders in F&O segment, 98% traded in options while 11% traded in futures during FY22 as compared to 89% and 43% respectively, during FY19.
5. During FY22, the share of young individual traders (20-30 years) participation in equity F&O segment. In index options and stock options went up beyond 30% each from nearly 11% in FY19.
6. During FY22, 89% of the individuals who traded in index options, 82% of the individuals who traded in stock options, incurred losses. During FY22, the average profit earned by profit makers was highest in stock futures, followed by index options.
7. During FY22, the percentage of loss makers were 74% and 67% for index futures and stock futures. During FY22, the average loss incurred by female loss makers as well as average profit made by female profit makers was higher than their male counterparts in all product categories.

The updated SEBI study further revealed that 93% of over 1 crore individual F&O traders incurred losses in equity F&O between FY22 and FY24. 9 out of 10 individual traders in the equity futures and options segment continued to incur significant losses. The aggregate loses of individual traders exceeded INR 1.8 lakh crore over the 3 year period between FY22 and FY24. Over 75% of individual F&O traders in FY24 have declared an annual income of less than Rs. 5 lakh. Despite consecutive years of losses, more than 75% of loss-making traders continued trading in F&O.

Independent of above, there is also data to suggest that number of young investors under 30 years of age bracket has doubled from 2020 to 2024.

The Covid-19 lockdown has made a huge impact on the investor demographics, so much so that, parents who are finding it difficult to convince their children to join the family business or even take up a salaried full-time job, because the Generation Z are attracted to the charm of stock market trading. The constant urge to indulge in some form of activity is real and for these traders, it is difficult to practice the art of doing nothing, or creating wealth through long-term investing. This eruption of hyperactivity in derivative markets, particularly by individual players, is not only acting as a deterrent in capital formation, but is also threatening to hurt investment and growth, by endangering both investor protection and market stability.

The Securities and Exchange Board of India (SEBI) by circular dated 1 October 2024, tightened the norms for futures and options (F&O) trading, by raising the entry barrier and making it more expensive for retail investors to trade in F&Os. This new framework is meant to create a more stable, transparent, and investor-friendly F&O market while minimizing undue risks for participants.

1. Removal of Calendar Spread Benefits on Expiry Day

A calendar spread is an options trading strategy that involves buying two options of same type viz: put or call, simultaneously. These options are for the same underlying stock and have the same strike price but different expiry date. Traders hold positions across different expiries, known as calendar spreads, and this provides margin benefits and reduces the margin requirements. On the expiry day of the F&O contracts, there's a higher risk that the price of the contract expiring can move differently from contracts expiring at a later date. Calendar spread benefit means that on expiry day, a client not having enough margin to sell Nifty or Sensex options, would sell in the current expiry, and buy the same options in the next expiry. This would reduce the margin needed to be placed to sell the options in the current expiry, as the purchase of same options in the next weekly expiry would effectively become a hedged position. This benefit is now proposed to be changed to prevent systemic risk, in the event there is sudden adverse movement of markets on expiry day. To manage this risk, SEBI has decided that traders will not get any margin benefits for calendar spreads on the day of expiry for contracts expiring on that day from 1 February 2025. Starting 1 February 2025, there will be no margin benefits for calendar spreads on expiry day i.e. the benefit of offsetting positions across different expiries shall not be available on the day for contracts expiring on that day.

2. Intraday monitoring of positions limits

Position limit in F&O is the maximum amount of positions a trading member can hold in F&O contracts. This position/trading limit serves as a protective measure against excessive speculation. Position limits for various products and participants are specified by SEBI and is monitored by stock exchanges at the end of the day for a client and a broker. On the day of expiry, given the skew in volumes witnessed, there is a possibility of undiscovered intraday positions beyond permissible limits. Position limits is required to be complied with market participants at all points of time and it's prudent to have a check on it for its breach even during intraday or on real-time basis. Currently this limits are monitored at the end of each day. Accordingly, it has been proposed that these position limits shall be monitored by clearing corporations / stock exchanges even on intra-day basis from 1 April 2025.

3. Minimum contract size for index derivatives

Contract size is trading in standardised amount of underlying stock that us being bought or sold. Effective 20 November 2024, for all new index derivatives contract, the value shall not be less than Rs. 15 lakh at the time of introduction of derivatives contract. The minimum value of contract is fixed in such a manner that the contract value or derivative on day of review is between Rs, 15 lakh to Rs. 20 lakh. The contract size prior to this change was between Rs. 5 lakh and Rs. 10 lakh. This change in lot size has direct implication on the trading volumes because of higher capital requirement for a trader to trade in F&O. Higher lot size ensures that the resulting notional value when multiplied by the market price remains higher than Rs. 15 lakh. Trader has to now pay more to enter into a index derivative trade. Similarly, an option seller will require higher margin for trades. Thus, for example, NSE increased the lot sizes of Nifty 50 from 25 to 75 and for Bank Nifty increased the lot size from 15 to 30. Similarly, BSE increased the same from 10 to 20 for Sensex contracts and from 15 to 30 for Bankex contracts. These changes to lot size have been made applicable to all new index derivatives contracts, including – weekly, monthly, quarterly and half-yearly contracts.

4. Rationalisation of weekly index derivatives products

Effective 20 November 2024, weekly derivatives contracts are available only on one benchmark index for each exchange. Prior to this, weekly expiry index derivatives contracts were offered by stock exchanges in addition to monthly contracts. Different stock exchanges were offering short tenure options contracts which expire every day of the week. Expiry day trading is typically speculative in nature. Large open interest and abnormal trading activity close to expiry have implications for market stability as well. Since there was expiry of weekly contracts on all five trading days of the week across indices and exchanges, it would typically lead to speculative money moving from one expiry to another expiry every single day, ultimately resulting to increased volatility during closing time, speculation on every contract expiry day and poor profitability for individual investors. In response to this, BSE (circular dated 3 October 2024) discontinued weekly index derivatives contract for Sensex and Bankex. NSE (circular dated 10 October 2024) discontinued weekly index option contracts for Bank Nifty, Nifty Midcap Select and Nifty Financial indices. NSE continues to offer weekly expiry options only for Nifty 50 Index (Thursday of every week) and BSE offers Sensex weekly options (Tuesday of every week [existing Friday] with effect from 1 January 2025). This is expected to minimize market disruptions and enable traders to focus on limited set of options and reduce market volatility.

5. Increase in margin near options contract expiry

Effective 20 November 2024, an Extreme Loss Margin of 2% is applied to short positions on expiry day to cover potential risks due to increased volatility. ELM is additional margin charged by stock exchange to cover risk of losses beyond the predicted levels (Value at Risk margin). This increased ELM is calculated as a percentage of contract value, and does not provide leeway to consider hedge benefits. This is intended to protect investors from extreme market fluctuations especially during high-volume trading sessions.

6. Upfront collection of options premium from options buyers

There is no explicit requirement of upfront collection of options premium from options buyers by trading members, unlike upfront collection of margin for futures position (short and long), and short options positions. Effective 1 February 2025, trading members will now have to collect net options premium payable at the client level, apart from collecting initial margin and extreme loss margin. This will considerably increase the margin required to place such orders. This is to avoid any undue intraday leverage to the end-client, and to avoid any exposure beyond the collateral at the client level. For example, if a client places an order for Rs. 5,000/- premium, the client should have Rs. 5,000/- as collateral margin, upfront before placing the order. Though the majority of brokers collect option premiums upfront from option buyers, the practice of some brokers (albeit permitted) without client having adequate margin is now sought to be prohibited. This shall be included in the intraday snapshots conducted by Clearing Corporation for verification of upfront collection of margins, and for imposition of penalty in the event of non-compliance.

Conclusion:

The above norms, some of which have already been implemented since 20 November 2024 have raised certain concerns around the impact that they may have on trading volumes, liquidity, including the dip in the revenues for stock exchanges and stock brokers. Insofar as stock brokers are concerned, impact on their business because of the above norms, will also depend on the kind of customers (retail / institutional) which contribute to their revenue from the F&O segment.

No doubt, the derivatives markets enhance price discovery and market liquidity, but without appropriate risk management tools, there could be higher risks of market manipulation, increased volatility, consequently resulting in investor interest and protection being compromised. One of the primary responsibilities of SEBI is to protect the interest of investors, while promoting the development of and regulation of the securities market. Indian Derivatives market turnover has significantly surpassed cash market turnover. Post covid era has seen a heightened activity from retail investors and therefore it becomes more so important for SEBI to safeguard interest of these investors, even if the consequence of this is that the fine line between regulation and over-regulation gets blurred.

On a separate but related note, the ill-effects of trading on mental health (stress, anxiety, depression, undertaking compulsive trades, boredom on trading holidays etc.) of a trader (and those dependant on the trader / relatives) is often ignored, not much spoken about and is an underrated topic of discussion. With rewards come great risks, which those trading may want to downplay. You only see screenshots on social media posted by a trader of profits earned by them from F&O trading, but the screenshots of the losses made are rare. We could discuss these aspects more, but that's a discussion for another day.

Fred Schwed Jr., once said – "Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investment is an effort, which should be successful, to prevent a lot of money from becoming a little."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.