Getting equity derivatives right

Retail participation has moderated, but questions around suitability, market resilience and the dominance of short-term trading remain

Derivatives and speculation aid price discovery, improve market depth and allow risk management. They are important for sustained capital formation.

 

That said, since the Securities and Exchange Board of India (Sebi) released its first study of futures and options (F&O) trading in January 2023, three aspects of equity derivatives have warranted attention.

 

First, nine out of 10 individual traders have consistently lost money in F&O, principally in index options.

 

Second, cash-equivalent volumes in index options on expiry days were as much as 700-800 times underlying cash-market volumes. At expiry, prices determined by a relatively small cash market could settle index-option exposures several hundred times larger. This raised concerns about market stability and manipulation, with some echoes of the vulnerability exposed by the London Interbank Offered Rate scandal.

 

Third, India’s derivatives market is overwhelmingly short dated. Weekly index options have proliferated, with much of the trading occurring on expiry day. Research suggests that, under some conditions, such trading can increase market volatility.

 

The expiry-day lure of index options

 

Selling options and trading futures requires substantial margins. Buying an option requires only the premium, which can fall to a few hundred rupees as expiry approaches. Index options are also cash settled, requiring no delivery of stocks.

 

Initiating positions by buying index options on expiry day and churning them within minutes can become akin to putting coins into a slot machine. Occasionally, the bet pays off and the coins jingle.

 

The odds, however, are stacked against the small trader. They trade over the same short horizons as sophisticated proprietary and institutional traders equipped with algorithms and high-speed market access.

 

The latest Sebi study illustrates the asymmetry in outcomes. In FY26, individuals incurred gross trading losses of around ₹72,000 crore in F&O. In contrast, proprietary traders made gross trading profits of around ₹44,000 crore and foreign portfolio investors or FPIs around ₹14,000 crore. Individual traders also incurred transaction costs of around ₹25,000 crore in brokerage, securities transaction tax (STT), exchange, Sebi and other fees. None of this implies wrongdoing by anyone. But the outcomes do raise questions about the appropriateness of such trading for small individuals.

 

Why regulation had to be calibrated

 

Exchanges, large brokers, and proprietary traders derive substantial revenues from F&O. While smaller individuals are dispersed and lose money, they too are willing participants, even if the suitability of their participation can be questioned. There is ample interest in letting things be.

 

Given the three concerns above, however, there was a case for regulatory review. For Sebi, the need to go about this thoughtfully went beyond managing real or imagined whispers in the corridors or protecting anyone’s revenues. Markets are complex. Unless there is a serious market failure, there is merit in proceeding carefully, based on data, analysis and consultation. Abrupt large-scale intervention can have unintended consequences across the wider market.

 

Sebi, therefore, proceeded incrementally. Its July 2024 consultation paper specifically targeted hyperactivity in expiry-day index options. Stakeholder suggestions were reflected in the final October 2025 measures, which sharply reduced weekly index-option expiries and increased the cost of expiry-day trading.

 

Sebi’s February 2025 consultation then sought to address market-stability and manipulation risks. Again, consultation produced refinements before implementation in May 2025. One important outcome was to measure index-derivative exposures on a cash-equivalent basis rather than on net notional value. This limited the size of the positions that anyone could carry into expiry to mitigate the risks from very large derivative positions being settled against a much smaller cash market.

 

There is a related institutional issue. As argued in these columns, exchanges are competing commercial businesses that also perform important first-line regulatory functions. There is merit in considering housing these regulatory functions in a separate, non-commercial entity, particularly when regulatory decisions have significant implications for exchange revenues.

 

What has happened since

 

The latest Sebi F&O study offers some encouragement. Active individual F&O traders declined 18 per cent in FY26, from 10.6 million to 8.75 million, the first annual decline since FY16. The decline was particularly pronounced among smaller traders. Aggregate individual losses fell 18 per cent in FY26, although the average loss per trader rose marginally.

 

Yet the same study points to continuing concerns. Of the 12.2 million individuals who traded derivatives during FY25 and FY26, 35 per cent had no underlying equity portfolio. Some 78 per cent had portfolios below ₹1 lakh and accounted for 70 per cent of total losses. Loss incidence declines consistently as equity holdings increase.

 

Income data tells a similar story. About three-fourths of traders for whom data was available reported annual incomes below ₹5 lakh; they accounted for 53 per cent of losses.

 

Speculation is legitimate. But when investors with low incomes and little underlying equity exposure take large positions in complex derivatives and consistently lose money, it is reasonable to review suitability and appropriateness standards.

 

The remaining structural issues

 

Despite the increase in cash market volumes over time, at expiry, large index-option exposures can still be settled against a much smaller volume of trading in the underlying cash market. Whether the mismatch has narrowed sufficiently since the May 2025 measures were introduced needs to be evaluated.

 

We should further deepen the cash market. Strengthening the securities lending and borrowing mechanism (SLBM) and eliminating STT on cash equities are worth considering.

 

In addition, while expiry-day index-option turnover fell from 70 per cent in FY25 to 59 per cent in FY26, 97 per cent of the turnover still occurs within seven days of expiry, and barely 1 per cent beyond 10 days.

 

That is hardly a mature derivatives term structure. Margin requirements for longer-term contracts perhaps deserve re-examination, particularly for spread and basis trades where economic risk may be considerably smaller.

 

The objective is not more regulation; it is safer and more sustainable equity markets. There has been some moderation, but suitability, the imbalance between derivatives and underlying markets, and the tenor of F&O remain open issues. The debate should continue, with the medium-term health of the ecosystem in mind.

The writer is a former wholetime member of Sebi.

 

The views are personal