Households lose Rs 60,000 cr a year on F&O gambling! The risk explained

Stock market regulator, Sebi, has once again raised an alarm about a risky investment trend: futures and options (F&O) trading. Everyday Indians are losing huge amounts of money, up to Rs 60,000 crore a year, by gambling on F&O contracts. Sebi chief Madhabi Puri Buch says this is a serious issue that could hurt the overall economy.

"If Rs 50,000-60,000 crore a year is going away into losses in F&O whereas that would have been productively deployed as may be the next IPO round, maybe MF, to other productive purposes, why is that not a macro issue?" Buch said.

What are F&O contracts?

 

Imagine you think a stock price will go up. You can buy the stock itself, but F&O contracts offer a riskier way to bet. They're basically agreements to buy or sell a stock at a certain price by a certain date.

Why are they risky?

Most F&O bets (around 90%) end in losses! Unlike buying a stock and holding it, F&O contracts have a deadline. If your prediction is wrong by that date, you lose your money.

"Unlike stocks, where price movement is more straightforward, F&O pricing is complex and a function of multiple variables, such as the volatility of the stock, time till expiry, strike price, discount rate, and current stock price.Additionally, F&O pricing is often swayed not solely by fundamentals but by market frenzy and knee-jerk reactions. External elements like market sentiment, speculation, and sudden market reactions can contribute to occasional irrational price fluctuations in the derivatives market, more so than in the stock market," said Piyush Syal of Value Research. 

Unscrupulous business model 

Derivatives serve as the lifeblood of brokers, constituting a vital aspect of their business model, as per Value Research. 

The industry's primary goal is to boost derivatives trading volumes, with participants actively steering clients toward F&O. 

"On prominent online brokerage platforms, generally a flat fee of Rs 20 is levied for each executed derivative trade. Zero brokerage is charged for equity trades. This is a testimony that brokers' profitability is intricately linked to the overall volume of derivatives trades.Further, SEBI, in its report, has highlighted that transaction cost as a percentage of total net trading profit was 15 per cent in FY22 and transaction cost as a percentage of total net trading loss made by loss makers was 23 per cent in FY22. This shows that frequent trading resulted in higher transaction costs," said Syal.

Margin Calls: 

Another risk associated with F&O trading is the potential for a margin call. This occurs when the value of your position declines sharply, and your broker demands additional funds to maintain the position.

How it works:

•  F&O trading involves leverage, allowing you to control a larger position with a smaller amount of capital.
•  If the market moves against your position, the value of your investment can decline rapidly.
•  When the value of your position falls below a certain level, your broker will issue a margin call, requiring you to deposit additional funds.
•  Failure to meet the margin call can lead to the forced liquidation of your position, often at a loss.

•  A margin call can force you to sell your position at an unfavorable price, regardless of your investment strategy.
•  Leverage can magnify both profits and losses, increasing the risk of significant financial setbacks.
•  Sudden price movements can trigger margin calls, leaving investors with little time to react.

"The F&O segment appears lucrative for high returns, but it operates as a zero-sum game . Unlike equities, where everyone benefits from a company's growth, F&O profits come at the expense of others' losses, creating a scenario where your gain relies on someone else's loss. Given this, we recommend avoiding F&O," said Piyush Syal of Value Research.

What's Sebi doing about it?

Sebi is proposing new rules to make F&O trading less attractive to everyday investors. These include:

• Limiting the number of times F&O contracts can expire each week.
• Increasing the minimum amount of money needed to invest in F&O contracts.
• Requiring investors to pay the full price of the option upfront, instead of just a deposit.

In recent years, there has been a surge in stock market participation in India. According to data from the Association of Mutual Funds in India, investments just through the SIP route (systematic investment plan) stood at Rs 1.99 lakh crore in 2023-24, more than doubling from Rs 92,693 crore in 2018-19. But, alongside there are concerns over the sharp surge in trading in futures and options (F&O) by retail investors.

Earlier this year, Sebi proposed a several measures to prevent speculative trading, such as gambling in index derivatives, which include curbing multiple option contract expiries and increasing the size of options contracts.  

A Sebi study had earlier pointed to 90 per cent of the trades resulting in losses. The capital markets regulator also came up with a consultation paper on Tuesday proposing ways to limit the activity. 

The surge in retail participation in the derivatives market has coincided with a significant increase in turnover, from Rs 4.5 lakh crore in 2018 to Rs 140 lakh crore in 2024. However, this growth has been accompanied by a steep rise in losses, with 90% of traders incurring negative returns.

To curb excessive speculation, Sebi is proposing several measures. These include increasing the contract size for F&O contracts, reducing the frequency of contract expiry, and mandating upfront collection of option premiums. The regulator is also considering stricter norms for investment advisors and exploring ways to make the Application Supported by Blocked Amount (ASBA) system mandatory for all qualified brokers.

Currently, index-based contracts expire daily. Sebi is considering allowing only one weekly contract per index to reduce short-term speculation.

 To deter small investors from high-risk trades, Sebi has proposed hiking the minimum contract size  from Rs 5-10 lakh to Rs 15-20 lakh in the first phase, and further to Rs 20-30 lakh subsequently.

Sebi also wants to prevent excessive leverage by requiring investors to pay the full option premium upfront, instead of the current practice of blocking collateral.

As the paper said, "Options prices depending on the moneyness move in a non-linear way and thus carry very high implicit leverage. These are timed contracts with possibility of very fast paced price appreciation as well as depreciation. In order to avoid any undue intraday leverage to end client and to discourage any market wide practice of allowing position beyond the collateral at the end client level, it is desirable to mandate collection of options premium upfront by TM/ CM from the options buyer. (At present, CCs block collateral at CM level for options buy trades)."

Sebi is also taking aim at a specific type of risky F&O trade popular with some retail investors: cheap options contracts with strike prices far away from the current market price. These are often referred to as "out-of-the-money" options because they have a low probability of becoming profitable.

 Sebi has proposed a system with tighter intervals for strike prices near the current market price (around 4% above or below). As the strike prices move further away (becoming more "out-of-the-money"), the intervals will widen (between 4% and 8%). This makes it less attractive to gamble on options with a very low chance of success.

Exchanges will be limited to offering a maximum of 50 strike prices for a single index derivatives contract at launch. This restricts the number of these "out-of-the-money" options available, making it harder for investors to chase unlikely bets.

 Sebi wants all stock exchanges to implement these changes in a coordinated manner to ensure a level playing field and prevent any exchange from offering a wider range of risky options to attract investors.

What will be the impact if these measures are implemented? 

"If the measures are replicated in the final regulations, volumes are likely to be hit both for retail participation (upfront premium collection and increase in lot size) and for HNIs/High Frequency Traders (removal of calendar spread benefit and additional margin for expiry). For brokers, price hikes can offset the impact," said Motilal Oswal Financial Services.