A losing proposition: Odds are against individuals in F&O trading

A new study by the Securities and Exchange Board of India (Sebi), titled “Analysis of Profits & Losses in the Equity Derivatives Segment (FY22-FY24)”, suggests that trading in derivatives is a losing proposition. Brokerages and exchanges charge fees, which add to the transaction cost, and net of such costs, derivatives trading is a zero-sum game with every loss equating to commensurate gains for some counter-party. The study indicates 93 per cent of the over 10 million individuals who traded in derivatives (futures and options, or F&O) during the period under review incurred average losses of Rs 2 lakh per trader (including transaction cost). The aggregate losses of individuals exceeded Rs 1.8 trillion. The biggest losers, about 400,000 traders, suffered average losses of Rs 28 lakh, including the transaction cost. In contrast, only 1 per cent of individual traders earned profits exceeding Rs 1 lakh, after transaction cost.

In FY24, proprietary traders and foreign portfolio investors (FPIs) as classes booked gross trading profits of Rs 33,000 crore and Rs 28,000 crore, respectively (before the transaction cost), while individuals incurred losses of over Rs 61,000 crore (before transaction cost). The profits were generated by trading algorithms, with 97 per cent of FPI profits and 96 per cent of proprietary profits arising from algorithmic trading. On average, individual traders spent Rs 26,000 per person on F&O transaction cost in FY24. Over FY22 to FY24, individuals collectively spent Rs 50,000 crore on transaction cost, with 51 per cent of such cost being brokerage fees and 20 per cent exchange fees. Around 43 per cent of individual traders are under 30 years, and about 72 per cent of traders live in places outside the top 30 cities. Also, the study claims over 75 per cent of loss-making individual F&O traders continued trading these instruments despite repeated losses.

Apart from ensuring that exchanges maintain transparent and fair trading processes, the regulator’s mandate extends to investor education. Studies like this serve a valuable purpose in that regard. Derivatives trading is an extreme illustration of the Pareto Principle with 7 per cent of individual traders making profits while the rest lose. However, beyond clearly pointing out that F&O trading is a losing proposition for individuals, there is not much the regulator can do. Indeed, it has also attempted to protect under-capitalised traders by asking for a review of contract sizes and margins. Given this study, it’s up to the individual to analyse their trading patterns and do the accounting. Smart traders will understand the implications and adjust trading strategies, or simply quit playing such highly leveraged markets.

From the institutional perspective, individual F&O traders serve an economic purpose. A comparison may be drawn with state lotteries. Every individual who buys a lottery ticket has an overwhelming chance of losing money and yet, in aggregate, participation generates useful revenues. A vibrant F&O market enables better price discovery, and participants can hedge more efficiently. In aggregate, traders help generate the volumes, which ensure high liquidity and low spreads. This is to the benefit of all traders, and especially useful for hedgers. However, retail traders would benefit from absorbing the lessons of this study at an individual level.