Assess maximum possible loss before entering F&O trade: Experts

Have sufficient capital as buffer to be able to meet additional margin requirements

Ever since the 2008 market crash, when retail investors sustained large losses in the futures and options (F&O) segment, the Securities and Exchange Board of India (Sebi) has been mindful of the risk these investors court when they enter this segment. Recently, Sebi chair Madhabi Puri Buch said that while the markets regulator doesn’t believe in restricting retail entry into this segment, it will provide additional disclosures to enable them to take informed decisions.

The number of demat accounts has risen from around 40 million in March 2020 to above 100 million in August 2022. “Many novice investors, lacking in understanding and access to right advice, have entered the markets,” says Sandip Raichura, chief executive officer (CEO)--the retail broking and distribution -- and director, Prabhudas Lilladher. Many of them have got directly into F&O trading.

Leverage risk

Leverage is a key source of risk in this segment. Suppose that a trader buys a contract worth Rs 10 lakh while paying a margin of Rs 1 lakh (assuming 10 per cent margin requirement). A 1 per cent upward movement of the underlying share or index would fetch him a gain of Rs 10,000. “Leverage magnifies downside risks equally. A 1 per cent downward movement will also produce a loss of Rs 10,000 in this case,” says Vikas Singhania, executive director, Trade Smart Online.

In many trading strategies, the gains are defined but the losses can be unlimited.

Traders without deep pockets are at high risk. “In many cases, just a 2-3 per cent movement of the underlying security can wipe out a low net worth trader’s entire capital,” says Raichura.

Liquidity risk

Many F&O contracts have low liquidity, which means there are very few buyers and sellers for them. Many contracts also lack depth (sellers have a limited number of securities to sell).  

“Price discovery goes for a toss in illiquid contracts. An unaware trader who enters such a contract may find it difficult to exit it, or may be forced to do so at an unfavourable price,” says Singhania.

Traders can place either a limit order or a market order. A market order gets executed at the best offer on offer. “Sometimes, in an illiquid security, the execution can happen at an absurdly high price because that’s the best price on offer,” says Tejas Khoday, co-founder and CEO, FYERS, a trading and investing platform.

Need to maintain margin

In a leveraged purchase in the F&O segment, if the market goes down, the trader needs to put up additional money at the end of the day to make up for the mark-to-market loss. If she is unable to do so, the broker liquidates her position, converting her notional loss into a real one. Even if the market recovers subsequently, the trader can’t benefit from it.      

Moreover, F&O contracts expire on a fixed date. Not only should the price movement be favourable, it should also happen within the contract period for the trader to make a profit. “If the contract expires in September and the price of the underlying asset moves up in October, the investor won’t benefit from it,” says Singhania.    

Menace of unqualified advisors

Unqualified and unregulated advisors are another source of risk. “Many of these advisors, for instance, promise to create a fixed-income stream for investors by investing in F&O. Such strategies may work for a while but eventually blow up,” says Khoday.  

What should you do?

Avoid utilising your entire capital as margin. “Maintain sufficient buffer so that you are able to pay the mark-to-market loss and maintain your position,” says Singhania.  

Before entering a trade, don’t dwell only on the potential profits. “Assess the maximum you could lose as well,” says Raichura.  

Also, have a stop loss in place. “Whenever a stop loss gets triggered, have the discipline to exit,” adds Singhania.

Traders shouldn’t depend on external advice. “In trading, decisions need to be re-evaluated several times during a day. The advisor will also not know how much money the trader has, how much risk she can endure, her time horizon, and so on,” says Khoday. All these factors make it difficult even for a well-meaning advisor to give quality advice.

Finally, limit trading to 10-20 per cent of your portfolio and invest the rest in long-term portfolios.

Safeguards that are already in place

• Peak margin rule has standardised the amount of leverage brokers can offer and thereby reduced risk for retail traders
• Large lot size requirement is meant to raise the entry barrier
• Only 50 per cent of margin can be put up in the form of shares, balance must be in cash; infusing more cash also reduces risk
• The regulator and the exchanges urge brokers to constantly ensure that trading volumes of customers are in proportion to their net worth