Excessive speculation

Proposed measures will reduce retail participation in F&O

The Securities and Exchange Board of India (Sebi) has released a consultation paper that lists seven proposals for changes in the derivatives segment (futures and options, or F&O) of the stock exchanges. These include proposals to increase the minimum size of derivatives contracts substantially, reduce the strikes available on an option, initiate surveillance of intra-day position limits, collect margins upfront for premiums, charge a higher “Extreme Loss Margin” on expiry day, and remove calendar spread benefits on expiry days. The net effect would be to raise the capital and liquidity requirements needed to trade in the F&O segment. This will force out some of the 9.2 million retail traders who regularly participate in F&O.

The regulator is of the view that the extra margin would protect against an extreme event affecting market stability on expiry day. Sebi is also attempting to discourage rampant speculation in the last hour of an expiry, when many traders decide to play the “lottery” to quote the paper. It is likely that there would be a dip in volumes as these measures are adopted and this could also mean larger spreads on premiums. These would make it more expensive for hedgers, or for institutions with funds in the proposed new Sebi asset class. Since the GIFT dollar-denominated Nifty option is unaffected, more volumes may move there.

The F&O segment would become more institutionally dominated, and probably feature lower volumes, and wider spreads, especially in the weekly options segment. Apart from reducing the risk of market instability, these measures would protect under-capitalised retail traders from themselves. The paper cites data to show India has very high ratios of F&O volumes. Moreover, F&O turnovers have grown substantially. The notional value of traded F&O contracts in 2023-24 was at 367 times the cash market turnover, while the premium value of F&O turnover was at around 2.2 times that of the cash market. With respect to individual traders, around 41 per cent of their turnover was in index options, and a high percentage of those positions — over 80 per cent — is taken on the expiry day. Moreover, since exchanges shuffle expiry dates, all five trading days of the week feature expiry of some index option. Normally, margins are lower for calendar spreads, where an option with a given expiry day is offset by an option with a later expiry day. Besides, position limits are usually calculated on an end-of-day basis, which implies these may be breached intra-day.

By removing calendar spread offsets on an expiry day, and asking for intraday position limits to be monitored, the regulator hopes to discourage speculation on the expiry date. Hiking the extreme loss margin provides some protection for the market against possible black swans near expiry. The paper cites data that indicates 85-90 per cent of retail traders lose money. The losses in 2023-24 amounted to around Rs 60,000 crore if costs are taken into account. This is over 25 per cent of the average annual inflows into mutual funds. Moreover, retail investors hold option contracts for an average of just 30 minutes. Increasing the minimum value of contracts from the current level of Rs 5-10 lakh to Rs 15-20 lakh and increasing again to Rs 20-30 lakh after six months would also force out retail traders who lack deep pockets. The measures proposed by Sebi may help to normalise trading and reduce risks, though it could mean loss of revenue for the exchanges and impose higher costs on hedgers.