News Excerpt:
In a discussion paper published on June 9, the Securities and Exchange Board of India (SEBI) proposed increasing the threshold for its criterion of sufficient liquidity and trading interest in stocks to allow derivatives of these assets to be traded.
What is Derivative Trading?
- A derivative is an agreement between two or more parties based on the value of one or more underlying assets. These assets could be anything from stocks and bonds to commodities like gold or oil.
- Derivative trading allows investors to buy and sell assets for the future. Derivative contracts are short-term financial instruments that come predetermined with a fixed expiry date.
Types of Derivative Trading: There are mainly two types of Derivative Trading in India.
- Options Trading: While buying an Option, one pays a premium. Also, for an option buyer, the maximum loss is the premium paid, however, profits are unlimited.
- Futures Trading: Futures are contracts that represent an agreement to buy or sell a set of assets at a specified time in the future for a specified amount. It is the owners' responsibility to buy/sell a contract at a pre-defined time and price.
Thus, Derivative trading is also called Future & Option Trading (F&O Trading).
Recent Trends of F&O Trading
- F&O trading volumes are estimated to have shot up 20 times since their pre-COVID level, due to a retail frenzy that has made India a global outlier.
- The F&O segment is meant to enrich the overall quality of market information and induce efficiency. Thus, SEBI should be able to pre-empt the crisis arising out of the growing number of retail investors, mostly with no retail trading and financial backgrounds.
Why is F&O more attractive?
- The chance of making outsized profits with small sums makes it all the more attractive.
- Investors can take large bets for brief periods with little margin money in the hope of not needing to pay the full money as net positions get settled.
- However, the risks can be very deceptive and tend to catch most lay investors unaware.
The risk associated with F&O Trading:
- The recent surge in retail trading of stock futures and options (F&O) demonstrates reckless investing.
- The SEBI conducted research in 2021–2022 and discovered that up to 90% of ordinary investors have experienced financial losses.
- Retail investors are more likely to lose because they are unable to time the market like professionals and are taking on more risk than they can handle or afford.
- This is why SEBI is proposing to tighten stock eligibility for F&O trading.
SEBI’s Stand on F&O Trading:
- SEBI said, “Without sufficient depth in the underlying cash market and appropriate position limits around leveraged derivatives, there can be higher risks of market manipulation, increased volatility, and compromised investor protection".
- To qualify for the F&O segment, a stock must meet a checklist that includes criteria such as being traded for at least 75% of all trading days and 15% of active derivative traders trading it over time.
- The criteria also include higher limits for average daily turnover of cash trades and contract premiums and a larger range of open F&O contracts on a rolling basis.
- Market participants aim to keep out shares that may be too risky for retail appreciation.
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