Sebi should educate investors but not over-regulate derivatives

There has indeed been a surge in derivatives volumes and retail participation in the equity F&O segment. The average daily turnover in F&O ran at ₹331 trillion between 1 January, 2023 and 25 Nov, 2023 – that’s about 115% higher than in 2022. Leverage in derivatives is high and turnover is reported in nominal contract value so this looks more impressive than it is, but it is a very high volume anyhow. Around 4 million individual investors participated in the F&O segment.

F&O volumes comprise over 99.5% of all trading volumes on the stock exchanges. Between FY19 and FY24, F&O volumes have risen 34 times – an unbelievable growth rate. Retail participation has risen about eight times, from less than five lakh in FY19. By comparison, the cash equity segment has an average daily volume of about ₹77,000 crore and has risen by around 110% since FY19. There are around 11-12 million direct retail equity investors. If we assume overlap, about a third of them play the F&O market as well.

A January 2023 Sebi report claimed 9 out of 10 F&O traders lose money, with about ₹56,000 loss per capita on average. The report noted that 90% of participants lost around ₹45,000 crore while 10% earned ₹6,900 crore.

Most of the volumes are generated by index options and the most popular contracts are index options with weekly settlements. Intuitively designed online-trading platforms have facilitated F&O trading and made it even more popular with retail investors. The high leverage makes it easy to make huge sums very quickly, and of course lose huge sums equally quickly. One way to discourage over-speculation would be to raise margins (thus reducing leverage), and of course Sebi can and should conduct campaigns to educate retail traders about the dangers of derivatives.

However, over-regulation or banning derivatives would be a bad idea, and the market should be allowed to continue to operate so long as there is no systemic risk. While speculative traders may make or lose large sums, they perform an important service.

Derivatives allow savvy investors to hedge many types of risk. Speculators who are trying to make a quick buck generate big volumes. The higher the volume and liquidity, the more efficient the market. This means lower premiums on options and quicker matchups on trades.

Stock and Index F&Os allow the hedging of commodity risks, forex risks, interest risks, and also political and geopolitical risks. An investor with a large equity exposure or exposure to a specific asset can use these instruments to limit the maximum loss or even generate a profit in certain situations.

The availability of options on multiple different stock indices gives Indian investors the flexibility to hedge a lot of events. For example, an investor with a well-diversified equity portfolio might choose to take a put option in the Nifty Index to protect the portfolio from a possible downside. A long-term investor with a large exposure to a specific stock might hedge that by taking the opposite position in the futures market.

An investor may also use options to exploit a “known unknown" in the financial markets. For example, during Budget week, or when the RBI’s Monetary Policy Committee is scheduled to meet, the investor may guess at likely policy decisions and take appropriate positions in the Nifty or BankNifty (which is sensitive to changes in monetary policy).

Political risks can sometimes be “known unknowns" as well. Elections, for example, cause volatility so an investor may use derivatives during those periods.

The utility of these instruments is why they were created. Speculators generate more liquidity, which enables lower costs which benefit hedgers. If Sebi is confident that systemic risks will not arise, the regulator should warn but not over-regulate.