The Indian stock market, which dates back to 1875, is among the oldest in Asia. That year marked the founding of the nation’s first stock market, the Bombay Stock Exchange (BSE). In the 19th century, trading took place under a banyan tree in front of Mumbai’s town hall. Today, it takes place electronically in a notable historic building on Dalal Street in the city’s centre.
The Indian stock market environment changed dramatically when economic liberalization began in the early 1990s. The opening up of the Indian economy encouraged international investment, resulting in an infusion of cash and rapid market development. India’s stock market value has risen sharply in recent years, placing it among the top five internationally.
India has a young population, which provides a considerable pool of prospective new investors entering the stock market every year. Despite its impressive expansion, the stock market confronts one big challenge – novice investors losing their hard-earned money in derivatives trading (mostly through F&O trading).
Thousands of people are drawn to trading derivatives to make instant cash. Experts on television networks or finfluencers on social media channels make frequent trading calls, which fuel those amateur investors’ greed. From less than 500,000 in 2019 to 4.5 million at present, India has seen an eight-fold surge in the number of active derivatives traders. In contrast, the number in the cash market has increased thrice, from around 3 million in 2019 to 11 million. India’s derivatives industry is 400 times larger than its cash market in terms of the trade volume.
The youth, as well as residents of tier II and III cities, have been drawn into F&O trading. The average age of an equities retail investor is 35 years, while those with discount brokers are 29 years.
F&O contracts are derivatives whose value is derived from an underlying asset. Traders place bets on the future growth and fall of an index or stock. Each futures and option contract has an expiry date. While ‘Futures’ require you to purchase or sell a contract at a predetermined price and quantity on the expiry date, ‘Options’ provide you the right but not the duty to buy or sell the contract. Future contracts have increased volatility since their prices react in rhythm with the growth of the underlying asset. Most retail traders prefer options because option premiums (or prices) appear to be less volatile.
However, options are complicated financial instruments with a significant possibility of losing money. Retail investors prefer ‘out-of-money’ options because the premium is lower. Out-of-money options are contracts that are significantly different from the underlying asset’s market price. Purchasing such options is comparable to purchasing a lottery, in that purchasers only stand to profit if the price of an underlying index or stock swings dramatically, which appears unlikely most of the time.
Assume that shares of Reliance Industries are now trading at 2,500. A trader predicts it will jump to 2,800 the next day, based on favourable quarterly earnings reports. He purchases 20 lots (1 lot = 250 shares) of call options at a premium of 30 per share. This indicates he is investing Rs 1.5 lakh, betting on the share’s upward climb. By investing 1.5 lakh, the trader risks 1.25 crore (5,000 shares multiplied by 2,500 each).
Retail traders are drawn to index options because the effective leverage on expiry day can be as high as 500x. A 3,000 purchase of option provides for 15 lakh in exposure, and they are essentially risky bets because the merchant typically holds an option for only 30 minutes.
In the Reliance Industries example, if the stock falls dramatically the next day, the call premium will decline in accordance with the current market price. If it falls to 25 from 30, the trader will lose over 90% of his investment. This is how the majority of retail traders operate and hence lose their money.
The Indian capital markets regulator SEBI (Securities and Exchange Board of India) has indicated that 90% of F&O traders lose money. To make matters worse, it is believed that the total losses experienced by these 90% loss-making F&O traders in 2022 were Rs. 45,000 crore, compared to the remaining 10% of traders’ earnings of Rs. 6,900 crore.
Greed makes it happen:
After a few wins, you see that it’s easy money. Then you go all-in. But everything vanishes in a single day or in two trading sessions or so. This is the most common experience among F&O traders. This doesn’t stop there, as amateur traders throw in more money, hoping to make a profit, but resulting in losing more money, turning F&O trading into a dangerous loop of spiralling losses.
Now comes the crucial question: why do individuals become caught into this cycle of loss? The straightforward answer to this issue is “greed”.
The entire environment contributes to this greed. Every business media channel features derivatives and intraday trading aggressively.
Many retail investors are readily swayed by electronic media or Finfluencers (short for Finance Influencers) on social media and invest in F&O trading. They lose money because they don’t invest enough time in developing the necessary abilities and discipline for handling money for a financial product with such a high level of risk. They play F&O like a lottery, frequently on expiration day, by purchasing contracts that are far out of money with relatively low premiums, as seen in the example above.
Not only is F&O trading becoming more accessible with the growing number of mobile-based trading apps, but traders do not require a large amount of cash to participate. Also, the premium costs of options have dropped dramatically with the introduction of contracts with weekly expirations, which is also making more retail investors to indulge in these trading. Previously, options had monthly expirations, which resulted in greater premium prices.
Not even a blink of your eye:
One may claim that SEBI’s study showed that 90% of traders lost money. So, some might question how the other 10% made money from it, and why can’t we join that 10%?
In his book ‘Flash Boys’, American writer Michael Lewis claims that the stock market is “manipulated” in favour of high-frequency traders (HFT), who employ complex computer algorithms to carry out orders at lightning-fast speeds. Their methods are so sophisticated that they can benefit handsomely on merely a one or two-point change in share price. A high-frequency trader’s trade taking time is barely noticeable, measuring only a millisecond. It takes 100 milliseconds to blink your eye, so it’s just a tiny fraction of a blink, but that’s enough time for a high-speed computer to perform its transactions.
While Lewis’ backdrop was Wall Street, HFT is widely used in India as well, where it is commonly referred to as ‘algo-trading’. HFT businesses co-locate their servers on the actual site of a stock exchange, allowing them to receive market data seconds before others. According to data from the National Stock Exchange (NSE), algo and co-location account for more over half of all equity derivatives trading (55.34%). According to data from the NSE, co-location fees are one of the stock exchange’s top three revenue sources. In 2023, the exchange generated 613 crore from the same, up from 433 crore the previous year. As a result, it is reasonable to believe that algo businesses make significantly more than their yearly co-location fees, and therefore the 10% of the population that profits in the F&O trading market consists majorly of institutional traders and high-frequency traders with far more advanced trading infrastructure.
Retail traders have also begun trading options using quant-based algo methods to increase their chances of profiting, but they must remember that when it comes to option trading, they are competing with institutional traders and HFTs who have a far more advanced infrastructure.
The concept of ‘Front-running’:
The author of the book ‘Flash Boys’ gathered the insights of various Wall Street professionals and concluded that High-Frequency Trading (HFT) is utilized to front run investor orders. Hence, we must also understand the concept of ‘front-running’.
Front running, sometimes referred to as tailgating, is the activity of engaging in an option, futures contract, security-based swap, or equity (stock) trade in order to profit from early, confidential information regarding a significant (“block trade”) pending transaction that will affect the underlying security’s price. In simple terms, it refers to the practice of engaging in a personal trade before doing a transaction in the exact same stock or instrument for a client’s account.
So, the essence of this is that High-Frequency Traders are already aware of the open positions of block trades and place their orders far in advance of any kind of market transaction occurring. This will result in profits for HFT traders and, consequently, losses for retail traders who are unaware of the front-running actions taking place in the market. Front running is viewed as a type of market fraud in several markets. It is illegal because the gains made by these HFT from non-public information at the cost of its own clients and at expense of the public market participants as well.
Future course of action:
Trading derivatives entails significant risk. Before dabbling with derivatives, one must first obtain the necessary knowledge and experience. Trading futures and options needs patience, dedication, and years of careful study. Financial experts even advise that retail investors avoid the F&O market entirely.
On the regulatory front, SEBI must address the major source of F&O losses by retail traders: the spread of F&O misleading information on electronic and social media. Brokers earn a brokerage fee for each order placed by a trader while buying or selling in the F&O segment. Brokers profit by promoting daily trades to retail traders. They will go out of business if they don’t do it. A brokerage company generates 80-85% of its revenue from F&O, with the remainder coming from the cash segment. SEBI must guarantee that these brokerages’ regulatory expenses are minimized so that their economic model becomes feasible and they do not end up promoting intraday and F&O trading onto their consumers for more revenues. Furthermore, television networks and internet platforms must emphasize that F&O is dangerous and can result in significant financial loss. Advertising standards should be consistent with those for gaming platforms. Ironically, the odds of losing in F&Os are higher than in online gambling. SEBI is taking measures to avoid novice traders from losing money in the F&O segment and from the stock market as a whole. But more awareness to these novice traders and new-comers has to be established by the veterans in the market.
