'Not all retail investors are speculators': Busting 5 common misconceptions about F&O trading

In the last two and a half decades, the Futures & Options (F&O) market has transformed from the biggest growth segment in India into the 'spoilt child' of the market.

After initially celebrating the surge in volumes in the Indian derivatives market, various government bodies—including the finance ministry, the Securities and Exchange Board of India (Sebi), the Reserve Bank of India (RBI), and exchanges—are now targeting so-called speculators, mainly the young investors who have entered the market post-Covid.

While it's true that speculation exists, it's unfair to blame the entire F&O market based on this alone. Let's bust the 5 common myths.

i) The majority of volumes in 'Index Options' are driven by large, sophisticated investors, not retail investors.

There is no doubt that volumes in index options have surged significantly in recent years due to the introduction of weekly contracts with nearly daily expiries. These index options were launched by stock exchanges with the blessing of the Sebi.

However, a bulk of the trading activity in index options is still driven by larger players, such as sophisticated institutions, high-frequency trading firms, proprietary trading desks, and very large market participants.

While the retail segment appears substantial in numbers, its contribution is likely in the 10 to 20% range. But it gets amplified because of the large number of people as against institutions.

ii) Options have two parties: A buyer and a seller. Option sellers are not typically retail investors.

A large portion of retail activity involves buying options, where the risk is limited to the premium paid. This activity is generally less risky than often perceived. Smaller investors tend to buy options due to the lower entry cost, while those with more capital generally engage in selling options, which require margins ranging from Rs 50,000 to Rs 5 lakh.

In contrast, buying options can be done with premiums as low as Rs 1,000, Rs 2,000, or Rs 5,000, depending on the ticket size. There is a need for regulations or checks and balances for option sellers as they could pose a risk to stock exchanges or the market.

iii) Not all retail investors are speculators; there are also retail hedgers.

SEBI's study has shown that 9 out of every 10 trades result in losses for investors. However, hedging is a cost, not a loss. Consider a scenario where you buy and sell put options at different prices. One side of the trade might be profitable, while the other experiences a loss. However, on a combined basis, you could still be making money. This complexity is amplified in multi-leg strategies. Imagine a strategy with seven or eight legs.

Some legs might incur losses, but the overall profit from the two winning legs could significantly outweigh those losses. "Calculating profitability in such scenarios becomes very difficult. It's essential to consider all legs and the net outcome to determine if the trade is ultimately profitable or not," says Vaibhav Sanghavi, CEO of ASK Hedge Solutions.

Globally, F&O instruments are used for risk management and hedging. F&O is a crucial tool for both institutions and small investors to hedge their positions. Also, SEBI just cannot remove the right of small investors to hedge their positions, say experts.

iv) Options premium should be taken as part of F&O turnover, and not notional value.

Initially, when option market volumes were small, exchanges used notional values to make the market appear larger and more appealing. Now that volumes have grown, using notional figures gives an exaggerated sense of the market's size and depth.

Some claim that F&O volumes are larger than the country’s nominal GDP. This is an unfounded belief. When you buy an option, you care only about the premium you pay, not the notional amount. "The whole issue of F&O trading volumes, especially options trading, is blown out of proportion due to the manner in which turnover is reported. The exchange reports the notional value. The ratio of premium to notional is often more than 1:100," says Jimeet Modi, Founder of SAMCO Securities.

v) Not directly linked to falling household savings.

A common argument against F&O trading is that household savings are being diverted from productive capital formation to speculative bets in the stocks and indices options segment. Is this really what is happening in our economy? Perhaps not truly the correct understanding. Dr. Manoranjan Sharma, Chief Economist at Infomerics Ratings, believes that a much more significant factor is the influx of money into stock markets via the SIP route by mutual funds.

On average, the mutual funds are mobilizing Rs 25,000 crore via SIP every month. Over 12 months, this totals more than Rs 3 lakh crore. "There are other factors like higher returns in other asset classes such as gold and real estate, and the high rate of inflation," reasons Sharma.