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Finance Minister Nirmala Sitharaman on Tuesday flagged the increasing retail participation in the derivatives market as a cause for concern.
“An unchecked explosion in retail trading in the futures and options market can create future challenges for the market, investor sentiment, and household finances,” Sitharaman stated at an event held at BSE in Mumbai.
Last month, several options traders experienced significant losses due to unexpected movements in underlying indices across exchanges, resulting in losses worth hundreds of crores.
What is retail trading in F&O?
Retail trading refers to individual traders who trade through a broker or on a platform. This can include both novice and experienced traders.
F&O explained
Futures
Futures Contract: An agreement to buy or sell an asset at a predetermined price on a specific future date.
Retail Traders: Individuals participating in these contracts, usually through online brokerage platforms. They might buy futures if they believe the asset's price will rise or sell if they think it will fall.
Options
Options Contract: Gives the buyer the right, but not the obligation, to buy or sell an asset at a predetermined price before or on a specific date.
Call Option: The right to buy an asset. Retail traders buy call options if they think the asset's price will rise.
Put Option: The right to sell an asset. Retail traders buy put options if they think the asset's price will fall.
Underlying indices: Underlying indices are benchmarks representing the performance of groups of assets, such as stocks. In India, these indices form the basis for various financial products, including futures and options (F&O). Examples include:
— Nifty 50
— BSE Sensex
— Nifty Bank
— Nifty IT
— Nifty Midcap 100
— Nifty Financial Services
Surge in retail investors
The Covid-19 pandemic and the advent of online KYC processes have triggered a shift in how families allocate their savings, moving away from traditional options like post office savings, fixed deposits, and chit funds towards equities. This shift has resulted in a surge of demat accounts, now exceeding 150 million. In the last decade, mutual fund assets have grown by 576%, reaching Rs 54.1 trillion. Average monthly SIP contributions have increased 4.5 times over the past seven years, now amounting to Rs 16,600 crore. Additionally, 580 companies have raised over Rs 3 trillion through IPOs.
Mehul Kothari, DVP - Technical Research at Anand Rathi Shares and Stock Brokers, explains, "Entry-level traders opt for options as they require very little capital. Furthermore, participation has skyrocketed due to the increase in the number of weekly expiries."
"Previously, we only had Nifty and Nifty Bank expiries, but now we also have Sensex, BankEX, FinNifty, Midcap Nifty, and others. This has led to greater participation and increased speculation," he added.
What are the risks involved?
Retail trading in F&Os can be risky and requires a good understanding of the market and strategies involved.
"The more expiries there are, the higher the chances of speculation. Option buyers often lose money, but now retail traders have started writing options. Selling an option carries unlimited risk, and in 2024 we have seen several instances of huge market spikes on or before expiry. As a result, the potential for significant capital loss is quite high when it comes to selling options," says Mehul Kothari.
How can sudden spikes in options prices be mitigated?
"Most of the time, spikes are caused by low liquidity. Newly listed weekly options lack liquidity, which leads to these spikes. Over time, as liquidity in newly listed options improves, the frequency of spikes may decrease. Additionally, limiting the number of indices for weekly expiry could reduce spikes, but this is not feasible at the moment. Global and geopolitical factors also impact volatility, making this year particularly challenging for option writers. In normal conditions, spikes are generally negligible," he explained.
BSE’s measures to mitigate sudden spikes in options prices
The BSE observed sudden spikes in two of its derivatives indices on February 2 and April 12, prompting the exchange to enhance its surveillance measures. Recently, it introduced “limit price protection,” which places restrictions on the price range for orders in the derivatives market.
The trading system will accept limit price orders within 60% of the reference price for option contracts and 3% of the reference price for futures contracts. Orders placed outside this price range will be rejected. This measure aims to protect against unusual trading activities and prevent erratic trades. When the price of an order is outside the specified range, the system will automatically reject it.
Safeguarding people's savings
According to Finance Minister Nirmala Sitharaman, household savings have shifted from traditional instruments to equities, and it is crucial to safeguard these savings.
"Exchanges need to ensure market stability, mitigate systemic risks, and adopt technology such as blockchain, AI, and big data to improve market efficiency," she said.
