Derivatives Trading: Is The Risk Worth The Gain?

What is the reason behind the rapid rise in futures and options trading? Is it only the lure of quick profits or is the trimming of brokerage a key part? Bhavya Rathod examines the various pros and cons of futures and options trading and probes the reasons why it is so risky for small-time traders 

A rapid surge in stock options trading in India has ignited enthusiasm among the country’s retail traders while raising concerns among regulators about the potential risks associated with such speculative fervour. The sudden and substantial growth in the trading of stock options has captured the attention of market participants, creating a dynamic landscape that is generating both excitement and caution. Regulators are closely monitoring this trend, recognising the need to balance the thrill of increased retail participation with the imperative to safeguard against potential risks and market volatility. [EasyDNNnews:PaidContentStart]

The enthusiasm surrounding option trading has been on a consistent rise, fuelled by the enticing prospect of rapid profits. Kiran Wagh, employed in a multinational corporation, found himself immersed in this trend. In May 2021, a college acquaintance added Kiran to a 500-member channel on the instant-messaging platform Telegram. Subsequently, he engaged in trading activities guided by blind stock tips, conventional futures and options trades, and paid courses disseminated on the platform by an individual professing to be a ‘trading guru’. Soon, this euphoria took hold, and by July 2021, Kiran felt self-assured enough to no longer rely on tips from Telegram channels. 

Regrettably, this newfound confidence proved to be short-lived. In the subsequent two months, Kiran incurred significant losses, depleting his entire capital through naked option positions—a strategy of selling an option without any underlying asset—inspired by a YouTube trader. Kiran found himself entangled in substantial losses, far surpassing his typical monthly earnings. Consequently, he had to resort to a personal loan at a notably high interest rate to sustain his current lifestyle. Currently, he is diligently working to repay his loans, underscoring the financial challenges that have emerged from his stock market endeavours. Kiran’s narrative mirrors that of numerous retail investors who have inundated India’s stock market in recent years.

Rise in Derivatives Trading

The surge in derivatives trading within the traditionally conservative markets of the country, where certain products like stock futures remain relatively expensive, has been propelled by modifications to options contracts that enable faster and more cost-effective wagers. This shift has coincided with the proliferation of online retail trading platforms. Data from exchanges that have significantly benefited from this upswing reveals that the daily average value of assets underlying stock options more than doubled from March to October, reaching USD 4.2 trillion. Notably, the ratio of the notional value of derivatives to cash trading has reached the highest levels globally. 

In October 2023, the National Stock Exchange (NSE) witnessed a robust average daily turnover of ₹ 318 trillion in options trading. Bank Nifty contracts dominated the index options segment, commanding a significant 40.7 per cent share last month. Nifty index options followed closely with the second-highest share at 34.3 per cent, while FinNifty accounted for 20 per cent. 

Simultaneously, the Bombay Stock Exchange (BSE) experienced a surge in derivatives trading, with options volumes that were non-existent between January and May 2023 reaching an average daily turnover (ADTV) of ₹ 30 trillion in October. 

A report released by the Securities and Exchange Board of India (SEBI) earlier this year highlighted that in the fiscal year 2022, 90 per cent of active traders in the equity futures and options segment incurred losses. Notably, the total number of derivative contracts traded on the NSE, which constitutes a significant portion of options trading volumes, amounted to ₹ 39.85 billion between April and September. This figure is closely approaching the ₹ 41.76 billion contracts traded in the financial year ending in March 2023. 

Remarkably, a substantial 99 per cent of these contracts are option contracts, enabling holders to speculate on the rise or fall of a stock or index by paying a fraction of the actual value of the shares. The notable surge in daily options trading turnover has raised concerns about investor protection. The market is exhibiting signs of excess, with retail investors seeking quick gains without a comprehensive understanding of the intricacies involved. On an average, individuals incurring losses recorded a net trading loss of nearly ₹ 50,000 crore in the fiscal year 2022. Strikingly, the average absolute net loss of a loss-making participant was more than 15 times the net profit earned by a profitable trader.
 

Brief Overview of Derivatives 

Derivatives represent a notably precarious and unprofitable avenue for inexperienced investors who possess limited understanding of capital markets and lack effective riskmanagement strategies. It’s no surprise that billionaire investor Warren Buffet once dubbed this practice a “weapon of mass destruction”, while his longstanding business partner, Charlie Munger, likened it to a “casino in drag”. Despite these warnings, a considerable portion of India’s youth continues to be drawn to derivatives trading. Derivatives trading involves the buying and selling of contracts or agreements, namely futures and options, based on underlying assets such as stocks, bonds, commodities or currencies. 

Futures necessitate a commitment to buy or sell these assets, whereas options provide the right (though not an obligation) to buy or sell at a predetermined price by a specified date—and it is essential to note that these transactions come with substantial risks. A call option is a financial agreement affording the buyer the option (without obligation) to purchase a stock, typically priced at, for instance, ₹ 100, at a predetermined price, let’s say ₹ 105. The buyer incurs a premium cost, as for example, ₹ 2, for this privilege. Should the stock’s price exceed ₹ 105, the buyer may choose to exercise the option, acquiring the stock at the agreed-upon price and realising a profit. 

Conversely, if the stock price fails to rise above ₹ 105, the buyer abstains from exercising the option, and the loss is confined to the paid premium. In contrast, the seller of the call option bears the obligation to sell the stock at ₹ 105 if the buyer opts to exercise the option. In return for undertaking this responsibility, the seller receives the premium as compensation. The seller faces unlimited risk, given that the stock price could potentially escalate to any level. However, the potential profit for the seller is restricted to the premium received. Equity future trading involves the execution of contracts based on a company’s stock, where investors engage in speculating on forthcoming stock prices. Participants commit to buying or selling a predetermined quantity of shares at a specified price on a particular date. 

The buyer is compelled to purchase the shares at the agreedupon price and the seller is obligated to sell the shares at the predetermined price, both actions executed on the specified date, regardless of prevailing market conditions. The potential for unlimited profits exists if the speculation proves successful, but conversely, losses can be unlimited or significantly high if it fails. While it’s not implausible to generate profits through thorough research of the intricacies of the capital markets and a well-defined strategy, the proportion of actual profit-makers remains skewed due to the inherently speculative nature of equity futures trading. 

Experienced practitioners in the derivatives market, wellestablished within the futures and options sector, have amassed a wealth of expertise, resources and financial capability. This positions them to execute intricate trades and implement meticulous risk management strategies, effectively mitigating the impact of significant losses. In the zero-sum landscape of futures and options trading, where losses borne by some traders offset gains achieved by others, the strategic allocation of capital by these seasoned traders contributes to amplifying their profits, often at the expense of less adept participants.
 

Real Winners and Losers 

The primary inquiry at hand revolves around identifying the entities that stand to benefit the most from the upsurge in trading volumes. Unquestionably, the primary beneficiaries are the exchanges and brokerage houses. In the fiscal year 2023, the central government is anticipated to accrue significant revenue, with the Securities Transaction Tax (STT) alone contributing an estimated ₹ 25,113 crore. Additionally, brokerage is projected to reach ₹ 29,000 crore, and exchange transaction charges are expected to amount to ₹ 10,334 crore. The Goods and Services Tax (GST), set at 18 per cent for financial services, is estimated to contribute ₹ 4,776 crore to the government’s coffers. 

It is noteworthy that a substantial proportion of STT collections are derived from the futures and options segment, which commands a significant share of the overall stock market volumes. Looking ahead to the fiscal year 2024, if trading volumes maintain their momentum similar to FY23, STT collections could potentially surpass the previous fiscal year. This can be attributed to the government’s decision to raise STT charges, particularly on options. The STT charged on options has been increased from 0.05 per cent to 0.0625 per cent. Previously, the STT on a turnover of ₹ 1 crore amounted to ₹ 5,000, but with the revision it has surged by 25 per cent to ₹ 6,250. This adjustment in STT rates signifies a potential uptick in government revenues derived from securities transactions. 

The STT on futures has undergone an increase from 0.01 per cent to 0.0125 per cent. Formerly set at ₹ 1,000 on a turnover of ₹ 1 crore, this rate has seen a 25 per cent augmentation, now totalling ₹ 1,250. In addition to STT, another facet affecting the financial landscape is the depository participant (DP) charges. For the fiscal year 2023, these charges, derived from trading activity on the National Stock Exchange (NSE), are estimated to amount to ₹ 2,840 crore. DP charges represent the fees that brokerages need to remit to depositories, such as the National Securities Depository (NSDL) or Central Depository Services (CDSL), where investors’ securities are held. Undoubtedly, the brunt of these changes falls upon retail investors. This impact is particularly pronounced for small traders, constituting approximately 60-65 per cent of the trading community, many of them being option buyers. 

Small options buyers typically enter the market with limited capital, usually around ₹ 10,000-15,000. Given the higher probability of small investors incurring losses, the additional burden of charges and costs becomes particularly noteworthy. On the other hand, for those involved in high-frequency trading (HFT), individuals operating as traders will need to incorporate these costs into their calculations. Nevertheless, the overall impact on this segment is expected to be marginal. The unfolding developments over the next couple of months will provide insights into how these changes reverberate through the market.
 

Conclusion

The spike in options activity is predominantly speculative rather than driven by hedging purposes. Ashish Chauhan, the head of the NSE, said in a message to investors: “Trade in derivatives by retail investors should be avoided because of the high risk involved. Be a long-term player.” The trading landscape for futures and options in India has witnessed substantial growth in recent years, particularly post the pandemic-triggered lockdown, with a surge of digitally savvy traders seeking quick gains in the stock market. The surge in interest in equity trading has been linked to individuals finding themselves at home with additional time and financial resources. 

In principle, this development should be welcomed by regulators seeking increased public participation in capital markets. However, it’s essential to acknowledge that futures and options trading is a realm for specialists. Consequently, the retail funds involved are more likely to reflect impulsive speculation rather than strategic bets on price movements or other investment strategies utilising derivatives for risk hedging. Based on anecdotal evidence, the allure of quick financial gains has played a role in fuelling India’s surge in futures and options activity. 

A mutual fund chief from the previous year expressed concern upon hearing individuals with limited knowledge of financial markets discussing profits from selling options—contracts granting the right to execute equity trades later at predetermined terms. While the risks associated with such transactions can be hedged, adverse price swings can still result in substantial losses. Illustrating the complexity, a study by SEBI has revealed a winner-loser ratio that emphasises the challenges. Only one in 10 individual traders turned a profit in the equity futures and options segment, with the remaining incurring an average loss of ₹ 1.1 lakhs in the fiscal year 2021-22. 

Among active traders experiencing losses, the average magnitude of these losses was more than 15 times the average profit of those in the green. Clearly, the odds are not in favour of retail participants, who often lack the data advantage and market expertise possessed by institutional players. Nevertheless, what draws them to high-risk derivatives is likely the potential for making substantial bets on volatile asset prices with relatively low upfront costs. Derivative transactions require minimal initial investment, with gains and losses settled only at the conclusion of the contract. Occasionally, these deals yield significant profits, creating a tempting allure that may cloud rational assessments of one’s future prospects. As indicated by the dismal win ratio in the futures and options segment, it appears easy for retail participants to be lured into overconfident trading that goes awry more often than it succeeds.

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