Warren Buffet, American businessman, investor and philanthropist, once said derivatives are financial weapons of mass destruction carrying dangers which, now latent, are potentially lethal.
While taking part at a Bombay Stock Exchange (BSE) event, Union Finance Minister Nirmala Sitharaman said more and more Indians are investing in stock markets and their household savings must be ring fenced. She red-flagged growing retail participation in the derivatives market.
Retail trading in F&O
“Any unchecked explosion in retail trading in the futures and options (F&O) market can create future challenges for the market, investor sentiment and household finances,” Sitharaman said.
She expressed concern that many retail investors have lost their hard-earned money in the F&O segment.
“Any unchecked explosion in retail trading of futures and options can create future challenges, not just for the markets, but also for investor sentiments and household finances,” she said. “Household finances have made a generational shift. We want to safeguard that and ensure that it is not going to be shattered.”
SEBI's move
The problem discussed by the Finance Minister is not something new. Sometime ago, the Securities and Exchange Board of India (SEBI) conducted a study on the net profit/loss incurred by individual investors in the equity F&O segment for FY19 and FY22.
The study periods were selected keeping in view the influx of individual investors in the last three years, so as to comparatively analyse the trends before and after the COVID outbreak.
In line with the study findings, SEBI mandated trading platforms to provide the following caution to investors:
* 9 of 10 individual traders in the equity F&O segment incurred net losses
* On an average, loss makers registered net trading loss close to Rs 50,000
* Over and above the net trading losses incurred, loss makers expended an additional 28 per cent of net trading losses as transaction costs
* Those making net trading profits incurred between 15-50 per cent of such profits as transaction cost
Long-term investment
Last November, SEBI Chairperson Madhabi Puri Buch said there was a 90 per cent chance that investors would lose money in the F&O segment. She advised them to go for long-term investment for wealth creation and to get a real rate of returns.
So, it is evident that the SEBI well recognises the risk involved in derivative trading.
But beyond this caution, SEBI has not taken any efforts to protect the investors from potential losses. It simply provides some lip service, which is similar to the statutory warning on a cigarette packet.
Financial literacy
Speaking at the Confederation of India Industry's (CII) Annual Business Summit 2024, Chief Economic Advisor Anantha Nageswaran noted that whenever financial sector development precedes national development, the story has not ended well for other countries as well.
“The Asian crisis of 1997-98 is a very important example,” he said. He reiterated that there was a need to reconsider 'sachetisation' of F&O trade because it requires a different kind of financial literacy.
'Sachetisation' refers to the process of making financial products and services available in smaller, more manageable packets for retail investors.
“Many of the people currently engaged in the market do not understand them…The sachetisation of F&O is something that we need to reconsider because the financial literacy required for trading in stocks is very different from that needed for trading in F&O," Nageswaran said.
Need to do more
The expressing of concern by the Finance Minister or other government officials may not be of use if there is no follow-up action on the ground.
Trading platforms and stock exchanges are indirectly inducing retail investors for wider participation, as it is remunerative for them.
Ideally, the purpose of any derivative trade (options and futures) should be a hedging operation. Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset.
Say, for example, you hold shares in company ABC. Although you believe in the company for the long run, you are worried about some short-term losses in that particular industry. To protect yourself from a fall in ABC company shares, you can buy a put option on the company, which gives you the right to sell ABC shares at a specific price (also called the strike price).
However, when one buys a put option of a company share, without any actual holding, it does not amount to hedging and it is mere speculation.
Take a cue from RBI
Here, SEBI must take a cue from the Reserve Bank of India (RBI), which has mandated that participants in foreign currency derivatives must do so only based on their underlying position. This means that the derivatives can be used only for hedging purposes and not for any speculative purpose.
During a recent press meet following a monetary policy announcement, RBI Governor Shaktikanta Das reiterated that underlying exposure for any Exchange Traded Currency Derivatives (ETCD) transaction is a must. He ruled out the possibility of reviewing the mandatory requirement.
However, as SEBI has not made any such regulation for stocks, speculators do huge trades in F&O in the stock market. Instead of using it to mitigate/reduce the risk associated with investment in stocks, market participants use derivatives for speculation and arbitrage purposes.
Allowing some speculation may be necessary for the purpose of having sufficient depth in the derivatives market. But a disproportionate amount of trading in derivatives is detrimental.
Way forward
The SEBI must initiate steps to reduce speculative activities in stock options and futures.
To start with, beyond a particular amount (for example Rs 1 lakh), only hedging operations can be allowed in F&O. This will save lakhs of individual traders who have been lured to derivative trades and who are incurring heavy losses.
This will also save small investors from this addiction. It is better to emulate the RBI, which allows derivatives only as a hedging instrument.
(The views expressed here are the author's, and do not constitute investment advice.)