In most markets, derivative trading
volumes average 5-15x of volumes in the cash market. As against this,
derivative volumes in India have already touched 400x of cash trading. The
gravity of the situation can be gauged from the fact that Germany, the second
in the line stood at 36x of its cash market. The Chairperson of SEBI commented
that Rs 50-60 thousand crore was going away from household savings into losses
in the F&O segment. It has thus become a major macroeconomic issue.
Before going deeper into these
losses and their consequences, let us first look at what these derivatives are
and why rapidly growing trading in derivatives is disturbing market regulators.
Derivatives are financial instruments whose promised payoffs are derived from
the value of something else, generally called the underlying. The underlying
could be stocks, commodities, currencies, or even indexes. They are essentially
designed to hedge or contain certain risks.
One of the derivatives is Futures.
It is one of the oldest innovations in the financial world. Since the times of
Aristotle, futures have become the darling of market players —hedgers,
speculators, and arbitrageurs—as they are found to mimic the price of the
underlying asset better. better. A
financial futures contract is an agreement between two parties to buy or sell a
standard quantity of a specific financial instrument at a future date at a
price agreed upon today between the parties through an organized futures
exchange, say NSE/BSE.
Under a futures contract, a buyer
commits today to buy Reliance shares at a specified future date at a price
fixed today, and the seller makes the opposite commitment. A buyer thus acquires a long position while
the seller acquires a short position. When a position is acquired, both parties
are required to post an initial margin with the exchange. Thus, futures trading
facilitates leverage on margin, i.e., it enables investors to take large
positions with a small initial outlay of funds. If the price of the underlying
moves in the unintended direction, a trader may lose more than the initial
margin. Trading in futures thus can lead to either larger returns or larger
losses.
The second most actively traded
derivative is the Option. The buyer of an option has the right but not the
obligation to take delivery of the underlying asset. On the other hand,
the seller of an option must perform the contract, should the holder/buyer
of an option exercise. The buyer of an option must pay a certain fee known as
option premium to the seller to enjoy the liberty of this right.
Options are of two types: call
option, which gives the right to buy the underlying asset, and put option which
grants the right to sell the underlying asset at the agreed upon price. Let us
take an example to understand how options operate. Say, X company’s share is
priced today at Rs 500 and you expect it to increase to Rs 670 by a certain
predicted date. In this scenario, you must purchase a call option with a strike
price of less than Rs 670. On the expiry date, if the price of the X share
is above the strike price, you will exercise the option and make a profit.
On the other hand, if the market price is lower than the strike price, you will
not exercise the option. The net result of letting the option lapse is the loss
of the premium paid earlier to purchase the option. Option trading thus
provides scope for higher returns with a lower margin (option premium). This
leverage can also multiply potential losses.
Perhaps, it is this potential for
higher gains offered by the leverage that is luring retail investors towards
speculative trading in derivatives. A recent study carried out by SEBI revealed
that 93% of retail investors in the F&O segment made losses. The study also
pointed out that it is the foreign portfolio investors and brokers trading on
their proprietary books who are raking in profits owing to their deep pockets
and the ability to use sophisticated algorithmic trading tools.
Authorities conclude that trading
in the F&O segment is hurting individual traders badly. Here, it is also
worth recalling what Warren Buffett once said: “Derivatives are financial
weapons of mass destruction, carrying dangers that, while now latent, are
potentially lethal”. Yet gullible individuals, being unaware of embedded risks
in derivatives trading and lured by brokers with promises of riches, are
burning their pockets by trading in derivatives.
Against this backdrop, SEBI
constituted a 15-member working group headed by Padmanabhan to “suggest near-term and medium-term measures to enhance
investor protection in exchange-traded derivatives and to improve risk metrics
and risk architecture of ETDs, with a view to enhance market development and regulation”.
Accepting most of the group’s
recommendations, SEBI increased the minimum contract size for index futures and
index options from the current Rs 5-10 lakh to Rs 15-20 lakh and also mandated
upfront collection of option premiums to reduce speculative positions. In an
attempt to rationalize weekly index derivatives, it allowed exchanges to offer
only one benchmark index with a weekly expiry.
SEBI is also introducing intraday
monitoring of position limits, and increased tail risk coverage to address
the likelihood of losses from rare events. To address the significant trading
volumes noticed on expiry days and the potential basis risks thereof, SEBI said
that the benefits of offsetting positions across different expiries (calendar
spreads) will not apply on expiry days. According to the SEBI circular,
these measures, which are meant to protect investors and maintain market
stability, will come into force in a phased manner starting November 20, 2024.
No wonder, there would be strong
opposition to these changes from exchanges and brokers for they will impact
their business adversely. It is to be seen how SEBI steers through it.
Secondly, one wonders if these changes can rein in investors’ animal spirits!
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