The options exuberance is on; will Sebi panel fix more guard rails?

Trading in options may cost a lot more in future, as a top regulatory panel weighs ways to reduce excess speculation in the derivatives market.

The Padmanabhan committee set up by the market regulator may look into volatility in the context of risk management in options trading, the panel's chairman indicated, even as millions of retail investors burn their fingers in derivatives. The committee had suggested seven measures to curb the derivatives exuberance. These measures made their way to a Sebi consultative paper on tightening the derivatives framework in July end.

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"The Sebi committee's work is not over. After Sebi finalizes the proposed measures (whether to implement all seven together or one by one), the committee will examine technical issues like whether option pricing should be based on historical volatility or implied volatility," said G. Padmanabhan, a former executive director with the Reserve Bank of India, who heads the derivatives committee.

Mounting losses

The fresh tightening plans come in the backdrop of a Sebi study on Monday showing that aggregate losses of individual traders crossed ₹1.8 trillion during the three years from FY22 to FY24. Out of over 10 million individual F&O traders, 93% suffered an average loss of ₹2 lakh including transaction costs, the study showed.

The committee's remit will extend to examining technical issues dealing with options pricing in a bid to strengthen risk management and surveillance, two people aware of the process said.

According to one of the two people, Sebi is worried about the explosion in volumes in the last half hour of trading on option expiry days every week. Options priced far from the prevailing market price turn cheaper on such days, attracting droves of retail traders betting huge amounts, despite low odds of success.

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Currently, margins are computed on the basis of historic volatility or IV which changes with a lag, unlike implied volatility (HV) which is prone to abrupt changes. According to the person cited above, who spoke on the condition of anonymity, Sebi may recommend setting the margins based on the higher of the two, which would raise margin costs for traders, and discourage weaker hands from trying their luck. Higher volatility means higher margins for the trader, and vice versa.

Deviation from mean

Volatility is deviation of prices from a mean. Historic volatility calculates daily price deviations during the past 12 months to arrive at an annualized figure. Implied volatility is expected deviation from a mean based on how events, say, the US elections in November, play out.

"The current margin to trade an option comprises historic volatility and an extreme loss margin. However, if implied volatility is higher, that could be used in place of historic volatility," the second person said.

An "excessive" surge in IVs of certain options on expiry, where historic volatility remains relatively unchanged, could flag surveillance by Sebi into whether something was "amiss or irregular " in trading, the person said on the condition of anonymity.

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"Currently, based on Padmanabhan committee recommendations, Sebi has proposed around 70% increase in the extreme loss component of the margin to trade. Use of the higher of two (IV or historic) or to keep tabs on unusual spike in IVs at certain option strikes, could be considered for implementation," the second person said.

The Padmanabhan committee recommended raising the minimum lot size of derivatives contracts from ₹5-10 lakh to ₹15 -20 lakh at introduction and ₹25-30 lakh after six months; having just one expiry per week per exchange in place of the current five; increasing margins to trade a day before and on expiry days of options; rationalizing option strike prices; collecting upfront margins from option buyers against only from sellers; removal of calendar spread benefit on expiry day; and intraday monitoring of position limits.

The suggestions formed part of a Sebi consultation paper issued on 30 July, which received public comments from over 6,000 entities.

‘Domain of the market’

"Regulators do not typically regulate prices, which is an exclusive domain of the market," said M.S. Sahoo, former wholetime member Sebi and ex chair of IBBI. "However, regulatory measures like margins make transactions costlier or cheaper and, thereby impact market sentiments, volumes, prices, and volatility."

Options became a retail favourite after NSE introduced weekly contracts in 2019, with Nifty and Bank Nifty options among the most popular. The BSE re-launched weekly Sensex options in May 2023. While Nifty options expire each Thursday, Bank Nifty options expire on Wednesday and Sensex options on Friday. Nifty Select Midcap and Finnifty options, which are relatively less popular, expire on Monday and Tuesday.

The top 3.5% or 400,000 loss-making individuals lost an average of ₹28 lakh including transaction costs in FY22-24, the Sebi report released on Monday said. Only 1% of individual traders managed to earn profits over ₹1 lakh after adjusting for transaction costs. Over the three years under review, individuals collectively spent ₹50,000 crore on transaction costs, out of which 51% was broking fees and 20% exchange fees.

Also read | Sebi’s seven measures to tame the “tail that's grown bigger than the dog"

While individuals and others incurred a loss of over ₹61,000 crore in FY24 (ex-transaction fees), proprietary traders and foreign portfolio investors (FPIs) as a class booked profits of ₹33,000 crore and ₹28,000 crore respectively in FY24.

"Most of the profits were generated by larger entities... with 97% of FPI profits and 96% of proprietary trader profits coming from algorithmic trading," the study noted. "Over 75% of individual F&O traders in FY24 had declared an annual income of less than ₹5 lakh."

The study also said that despite consecutive years of losses, more than 75% of loss-making traders continued trading in F&O. The study is a follow-up of a report published by the regulator in January 2023, which found that 89% of individual equity F&O traders lostmoneyinFY22.