As SEBI cautions, futures and options trading is not for the faint-hearted

Mahadevan, a middle-aged professional, recently started investing in the stock market through the cash segment (wherein he can buy shares and hold them for life, vis à vis the futures segment, where he would need to settle the contract by a certain date). 

Over the past three-four months, Mahadevan’s investments have given him good returns. As he has already invested his funds, he consults his friends on how to increase his exposure. Some of them suggested he enter futures and options (F&O) in the derivatives market, where he can buy large quantities of stocks with some margin money or premium payment, as there is no need to pay the entire contract amount upfront. The suggestion sounded good to him.

Personal Finance: Should you book profit without dividend, or book loss after getting dividend?

He already had a trading account with an online brokerage firm. So, he opened the F&O window in the online share trading portal. To his surprise, he came across the following caution displayed on the share trading portal:

Risk disclosures on derivatives 

• Nine out of 10 individual traders in the equity futures and options segment incurred net losses.
• On average, loss makers registered net losses close to Rs 50,000.
• Over and above the net trading losses incurred, loss makers suffered an additional 28 per cent of net trading losses as transaction costs.
• Those make net trading profits incurred between 15 per cent and 50 per cent of such profits as transaction cost.

The portal would allow him to move forward only when he submitted an undertaking that he was willing to accept these risks.

Also read: SEBI may change mutual fund TER rates: What is TER, how does it affect investors?

There are any number of investors who enter the derivatives market (futures and options) and lose their hard earned money. According to a Securities and Exchange Board of India (SEBI) study, 45.2 lakh retail investors or traders entered the derivatives market – futures and options – in fiscal 2022. 

Word of caution

The display of caution has been made mandatory by the SEBI, India’s market regulator. According to a recent SEBI direction, all share brokers have to implement the display of caution or ‘risk disclosures’ by July 1. Some share trading portals have already followed suit.

The SEBI guidelines says, “Upon login into their trading accounts with brokers, the clients may be prompted to read the ‘Risk disclosures’ (which may appear as a pop-up window upon login) and shall be allowed to proceed ahead only after acknowledging the same.” Further, SEBI has prescribed that ‘risk disclosures’ shall be displayed prominently, covering at least 50 per cent area of the screen.

Earlier, SEBI had conducted a study to analyse trading by individual investors in the F&O segment for the period from FY19 to FY22. The findings of the study released in January 2023 are as follows:

Retail investors in equity F&O

The number of unique individual traders in the equity F&O segment saw an increase of over 500 per cent in FY22. The SEBI study pegged the number of investors trading through a sample of top 10 brokers in equity F&O segment at 45.2 lakh during FY22, up from 7.1 lakh during FY19, of which 88 per cent were active traders.

Personal Finance | Tax debate: Does a housing loan amount to savings?

During FY22, retail traders belonging to the age group 30-40 years had the highest share in participation at 39 per cent across all age groups. For younger individual traders aged between 20 and 30 years, the percentage share of participation was 36 per cent during that fiscal. The study showed that 75 per cent of individual traders were youngsters and middle-aged people.

Loss makers

According to the SEBI study, 89 per cent of individual traders in the equity F&O segment incurred an average loss of Rs 1.1 lakh during FY22, whereas 90 per cent of active traders incurred average losses of Rs 1.25 lakh during the same period.

Profit makers

Interestingly, only a minuscule number of investors made profits while trading in the equity F&O segment. During FY22, 11 per cent of individual traders made an average profit of Rs 1.5 lakh (see the table for more details).

Buffet’s word of caution

Warren Buffett believes that derivatives are “financial weapons of mass destruction”. The legendary investor refers to derivatives as a “time bomb”, which is a manifestation of a possible market deterioration if there is a sudden unwinding of derivatives positions.

A derivative is a financial contract whose value is tied to an underlying asset. The common derivatives include futures contracts and options.

Derivatives should be used ideally to hedge against a position. For example, if one is holding a particular share, he can enter into a sale contract in the futures market, so that if the price of the share falls, he will be protected as he will be holding a sale position also in futures.

Knowing the risks

Options trading is not for everyone, and it is important to understand the risks involved, especially when options are a decaying asset. There are varying degrees of risks involved with options that depend upon the strategy. Option buyers can have a limited loss but unlimited profit. On the other hand, option buyers may face situations of limited profit but unlimited losses.

Brokerage firms attract more and more individual investors into the derivatives market by offering them attractive plans. Most of the brokerage firms allow them to enter options trading with just Rs 20 per trade. For futures, they charge between 0.01 per cent and 0.05 per cent of the contract value.

The SEBI initiative to caution individual investors is a welcome step. But only time will tell how many investors take the caution seriously. No one can save someone who is determined to ignore all warnings.

(The writer is a retired banker. The views expressed here are his own, and do not constitute investment advice.)