Legendary investor Warren Buffett, called the Oracle of Omaha for his instinct to predict market trends, had issued a warning about derivatives more than two decades ago in one of his popular annual letters to the shareholders of his company Berkshire Hathaway: “We view them as time bombs, both for the parties that deal in them and the economic system.” He called derivatives “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”. Derivatives are contracts which derive their value from some underlying asset such as stocks and commodities. They could be used as an effective way to hedge risks or as plain speculation on the market trends.
As the Indian middle class mobbed the stock markets in the past few years, a class of new investors, greedier than wiser, began playing with the time bombs Buffett had warned against. Young people, out to make a quick buck or yearning for financial freedom, are trading in stock futures and options, the two popular forms of derivatives, like there’s no tomorrow.
Futures and options (F&O) trading involves contracts that derive their value from an underlying asset, such as stocks and commodities. Futures contracts obligate the buyer and seller to transact at a predetermined future date and price, while options give the holder the right, but not the obligation, to buy or sell the asset at a set price within a specific period.
Alarm bells have started ringing as various government officials notice the animal spirits going wild in the F&O segment mainly due to an influx of retail investors in a realm where only experienced investors used to operate.
RBI governor Shaktikanta Das on Tuesday said at ET Now Leadership Dialogues that the central bank as well as markets regulator Sebi have discussed the huge volumes in the F&O segment, amid concerns raised by finance minister Nirmala Sitharaman and senior government officials. “The volumes in the F&O market are very large, perhaps larger than the nominal GDP. We have discussed the matter with Sebi, and they are dealing with it,” Das said.
Govt planning to rein in F&O animal spirits?
As concerns swell among the authorities, a regulatory corrective measure could be taking shape. Sebi is considering a series of tweaks to its derivative trading rules, as it seeks to address risks arising from explosive growth in options trading, Reuters has reported based on information from sources.
The new rules could include higher margins for options contracts and more detailed disclosures, and are being considered after a series of meetings with exchanges, brokers, and fund houses over the past four months, the sources, with direct knowledge of the matter, told Reuters. One source who is a regulatory official said there was a need for appropriate risk disclosure and steps to prevent excessive speculation or possible manipulation. The first step the regulator is considering is a linking of options trading with underlying cash volumes in a stock, to contain the build-up of open positions in less liquid stocks, the sources said. In cases where there is excessive build-up of options positions relative to cash volumes, the margin requirement for trading options would increase, they said.
Sebi will also suggest increasing disclosures on index and stock options contracts, rather than just options activity and open interest as is now done, the sources told Reuters. The regulator is planning to ask exchanges to levy flat fees on brokers regardless of their turnover, the sources said, changing a practice of charging lower transaction fees for brokers with high turnover.
How wild is India’s F&O frenzy?
The F&O segment’s popularity is evident from its massive growth, with the monthly turnover in the F&O segment reaching Rs 8,740 lakh crore in March 2024, compared to Rs 217 lakh crore in March 2019. At the same time, the average daily turnover in the equity cash segment was Rs 1 lakh crore, while the F&O segment saw an average daily turnover of about Rs 330 lakh crore, Vinnaayak Mehta, Founder and Director of wealth management firm The Infinity Group, has told PTI.
In the fiscal year 2023-24, the notional value of index options traded on the National Stock Exchange (NSE) doubled to USD 907.09 trillion from USD 447.69 trillion the previous year, he added.
Of the 108 billion options contracts traded worldwide in 2023, 78% were on Indian exchanges, according to data from the Futures Industry Association(FIA). Retail investors make up 35% of derivative trading in the country. In April, 78% of trades done on India’s largest exchange, the National Stock Exchange were by investors trading less than 1 million rupees ($11,969).
“When we take pride in the fact that we have the world’s largest trading volume for futures and options we need to ask ourselves, is that a sign of progress or a sign of concern?,” V. Anantha Nageswaran, chief economic adviser in the finance ministry said at a CII conclave last month. A few days earlier, finance minister Nirmala Sitharaman had also expressed caution saying that an unchecked explosion in retail futures and options trading had the potential to create future challenges not just for markets but for investor sentiment and also for household finances. The FM had also said that household finances have made a generational shift from the post office and bank deposits to mutual funds and capital markets, and the government wants to safeguard and ensure that it is not going to be shattered.
Last year, Sebi had come out with a study which showed that nine of 10 individual traders in the equity F&O segment incur net losses. Following the study, Sebi chairman Madhabi Puri Buch had expressed surprise at the number of investors continuing to participate in the segment despite knowing the odds were not in their favour. F&Os are considered very risky because of the potential for significant losses as investors can take big bets with small upfront amounts.
Social media platforms are flooded with videos, vlogs, and posts showcasing extravagant profits from options trading. Influencers flaunt their gains, often with screenshots of substantial profits, creating an illusion of effortless wealth. Unfortunately, many young traders, driven by the fear of missing out (FOMO), dive headfirst into options trading without a clear understanding of the inherent risks and missing the point that these screenshots may be fake.
“It’s not about the volumes, but some newcomers are trading directly in options without having any knowledge or shares in the cash market, which is a concern for regulators,” Rajesh Palviya, head of technicals and derivatives at Axis Securities, had told ET last month. “Additionally, many unregistered influencers are encouraging new investors to trade in options by selling their strategies.”
(WIth inputs from agencies)
