Moth to a flame: Why are retail traders inexorably drawn to derivatives?

Why do sensible traders use these? Some hedge using F&O. Others play news-based events

Recent remarks by Madhabi Puri Buch, head of the Securities and Exchange Board of India (Sebi), the stock markets regulator, have focussed attention on retail speculation in the equity derivatives: futures and options, or F&O, segment. The Sebi chairperson said she was surprised at the retail investors’ interest in this market and advised them to stick to the cash segment.
 

“I must admit, I am always a little confused and surprised as to why people continue to do that (bet on F&O) knowing that the odds are not in their favour at all,” Buch said at the launch of the Investor Risk Reduction Access platform at the Bombay Stock Exchange in Mumbai.
 

Data from stock exchanges, along with a January 2023 study by Sebi, indicates startling F&O growth. In 2018-19 (FY19), around 700,000 retail traders took F&O positions; by end-FY22, there were more than 4.7 million. That is more than 500 per cent growth.
 

In FY22, 90 per cent of F&O traders lost money, with the average loss being Rs 1.25 lakh. The 10 per cent who made money made average profits of Rs 1.9 lakh. In addition, all of them paid transaction costs.
 

India is the world’s highest volume equity F&O market. Average Daily Trading Volumes in the F&O segment have run at more than Rs 330 trillion this calendar year (January to November 2023). This is more than 30 times as high as in FY19. Average daily volumes in the cash equity segment is around Rs 78,000 crore — that is 115 per cent higher than in FY19.
 

The F&O segment offers contracts for 193 underlying stocks and multiple indices. There are 46,000 contracts running at any time with different tenures. The bulk of the volume — about 99 per cent — is in index options for tenures ranging from a week to several months.
 

Complexity of the task
 

Options are complex instruments. There is a seller and a buyer. Options are puts or calls with a specified strike price and tenure. The seller has a limited profit (premium received) and potentially unlimited losses. The buyer has limited loss (premium paid) and potentially unlimited profits.
 

A put option gives the buyer the right but not the obligation to sell the underlying at the specified strike price. A call option gives the buyer the right but not the obligation to buy the underlying at the strike price. The buyer may exercise the right only when the position goes into profit. The seller’s maximum profit is the premium if the option expires without the strike price being hit.

The buyer could make many multiples of the premium paid.
 

The easiest way to understand options is to think of insurance. An insurance policy is an option. The insurer receives a premium for selling a policy. That is the maximum profit if the insured event doesn’t occur within the policy tenure. If it does, the insurer pays out many multiples of the premium.
 

A clever trader can combine positions in different options at different strike prices and tenures to limit losses and cut costs.
Let’s say, an underlying asset trades at Rs 90. A trader buys a call at Rs 100 strike price for Rs 1 premium and sells a call at Rs 110 strike price for Rs 0.5. Total cost — Rs 0.5. Potential gain Rs 19.5, if the underlying runs to Rs 110. An option seller could sell the Rs 100 call and buy the Rs 110 to limit profits to Rs 0.5 but limit maximum loss to Rs 19.5.
 

Margins are collected using complicated formulae to assess variables such as time to expiry, interest rates, difference between strike and underlying price, etc. One popular valuation method — the Black-Scholes-Merton Model — led to a Nobel in Economics in 1997 for Myron Scholes and Robert Merton (Fischer Black passed away in 1995). In 2000, Long-Term Capital Management, a hedge fund with Scholes and Merton on board, went bankrupt. That’s how hard option-valuation and trading can be.

Sense and sensibility
 

In India, the most popular options are weekly tenure index options. Many brokers charge flat transaction costs at so much per trade regardless of the trade value. Speculators are obviously attracted by leverage — a relatively small amount of money can fuel huge profits.
 

Why do sensible traders use these instruments?
 

The answer comes in two parts. Some smart investors hedge using F&O. Others play news-based events. Say, for example, an investor has a large, diversified equity portfolio and the Union Budget week is coming up. The investor may buy an index put and an index call as a hedge. This is called a “strangle”. If the market does swing a lot in either direction, one of those instruments may gain enough to offset any other losses.
 

Or, suppose it is monetary policy week at the Reserve Bank of India. Any changes in interest rates will lead to swings in the BankNifty index. So you might guess what the Central bank would do and take a BankNifty position. Similarly, if there is an election coming up, there could be market volatility. Or if there is a war happening somewhere, or a terrorist strike.
 

You can use these instruments to play news. There are all sorts of events that can be exploited by equity derivatives. If you expand the scope to commodities and forex (derivatives are also available in these assets), even more events and trends

are covered.
 

Retail speculators who play the market week after week, without necessarily thinking such situations through, do play an important and useful role. By generating volumes, they reduce premiums and make life easier for the smarter traders and investors. Of course, they also add to revenues for the stock exchanges and brokerages.
 

Now that the election season is well and truly upon us, you can expect market volatility. This is also likely to lead to even higher trading volumes and larger systemic risks.

Simply put, call them complex

Futures and Options are time-bound (“Wasting assets”). They expire on a given date. Futures are relatively simple instruments. A trader can go “long” on a future (buying) or “short” (sell the future). Though the price of a future is usually fairly close to the price of the underlying, it offers high leverage. Futures margin is usually around 10 per cent of contract value (10:1 leverage), sometimes higher. A 1 per cent swing in futures price will translate into 10 per cent profit or loss for the trader. Every futures profit is matched by the equivalent loss. This is a “zero-sum” instrument. Futures can be used to hedge cash positions — buy a stock and sell the future, for example.
 

Option are more complicated. A call option gives the buyer the right but not the obligation to buy at the agreed strike price. A put option gives the buyer the right but no obligation to sell at the strike price.
 

Let’s say, the Nifty is trading at 19,800. You can buy a call at 20500 strike and expiry on December 28. It will cost about Rs 130.

Let’s say the Nifty hits 21,000. Your return will be 500 (21,000 minus 20,500) — the profit is Rs 370. If the Nifty does not hit the strike by December 28, you lose the premium.
 

What about the option seller? The seller receives the premium upfront and hopes the option expires without being struck. 

If the option is struck, the losses may be unlimited. An option seller might buy an option as well to limit potential losses and reduce margins. For example, if a call option is sold at 20000 Nifty for a premium of Rs 405 and a call bought at 20500 (premium Rs 138). If neither strike is hit, the seller keeps Rs 267 (405-138). If both are hit, the maximum loss is Rs 233. The 20500 call “cancels out” greater losses even if the Nifty keeps rising.
 

By buying and selling option combinations, a smart trader can limit potential losses and reduce net premium paid, and also reduce total margin requirements.