New lottery: The human cost of F&O trade

“I knew a lockdown was coming, in line with other countries. I decided to bet on the stock market falling as a last lottery ticket to recover my losses,” Mehta recollects. “I bought put options expecting the markets to fall.”

In trading lingo, put options represent a bearish outlook while call options imply a bullish view of the market or a stock.

That’s exactly what happened. Not only did Mehta recover his losses but he also made a profit.

And then, he kept dabbling in futures and options (F&Os) in the following months. Amused by an expert who would often appear on television channels, he subscribed for his premium services. “Initially, all was good. But after two-three months, in 2021, his calls started going wrong. Whatever he would tell us to buy in the morning would fall by afternoon. I sensed a pattern,” Mehta recollects.

“After the market went on a downtrend, his language changed. He would tell us to hold on to his recommended stocks. My portfolio was already down 40%. I booked losses and invested the remaining money in Nifty Next 50 Junior BeES (an index fund),” he says.

Mehta broke down before his parents. “I had never taken a penny from them after I graduated. I had lost all my confidence.”

There are thousands like him who get allured to derivatives trading to make a quick buck. Incessant trading calls by experts on television channels or finfluencers on YouTube fuel their greed. The number of active derivatives traders in India has increased eightfold from less than half a million in 2019 to 4 million now. In comparison, in the cash market, the number has grown three times—from about 3 million in 2019 to 11 million. While the derivatives share in terms of volume is high world-over, it is among the highest (400 times the cash market) in India, a recent report by Axis Mutual Fund stated.

The young, as well as people from tier-II and III cities, have been sucked into F&O trading. And investors from India’s smaller towns have the same customer profile as that of online gaming companies. The average age of an equity retail investor is 35 years, whereas those with digital discount brokers is 29 years, similar to 31 years for online gaming companies, the report ‘Gamification of Indian Equities’ stated.

F&Os are derivatives contracts that derive their value from an underlying asset. Traders bet on the rise and fall of an index or a stock at a future date. All the futures and option contracts have an expiry day. While futures obligate you to buy or sell a contract at a pre-specified price and quantity on the expiry day, options give you the right but no obligation to buy or sell the contract. Future contracts carry higher volatility as its prices react in complete sync with the rise of the underlying asset. Most retail traders, therefore, opt for options—option premiums (or prices) are less volatile.

Nonetheless, options are sophisticated products where the probability of making a loss is high. Retail investors are mostly attracted to what is known as ‘out-of-money’ options, as the premium on these contracts is cheaper. Out-of-money contracts are contracts that are far away from the market price of the underlying asset. Buying such options is like buying a lottery— buyers only stand to gain if there is a big swing in the price of an underlying index or stock.

Let’s assume that the current market price of an Infosys share is ₹1,200. A trader expects it to rise to ₹1,500 the next day, betting on positive quarterly results. He buys 20 lots (1 lot equals 400 shares) of call options at a premium price of ₹13 per share. This means he is betting ₹1.04 lakh on the upside movement of the share. By investing ₹1.04 lakh, the trader is taking an exposure of ₹96 lakh (8,000 shares multiplied by ₹1,200).

The Axis Mutual Fund report stated that the effective leverage on an index option during expiry day could even be 500x, which is luring the retail traders. “A ₹2,000 option allows ₹10 lakh exposure and these are largely speculative bets a retailer holds an option on average for just 30 minutes,” the report stated.

In the Infosys example, if the stock falls sharply the next day, the call premium will also tank in line with the current market price. If it slides to ₹2, the trader will lose nearly 85% of his money. This is what happened with most retail traders over the last two years.

A 2021-22 report from the Securities and Exchange Board of India (Sebi), India’s market regulator, stated that 90% traders in F&O lost money during the year. Their collective losses? ₹45,000 crore against just ₹6,900 crore gains made by the remaining 10%.

Interestingly, the report pointed out that fantasy sports offer better odds than options trading for retail traders. “In fantasy sports, the take rate of the pot is 15%. For every ₹100 put in by the retail participants, they get ₹85 back. The skew is opposite in derivatives, with only 15% of the pot coming back to retail,” the report underlined.

“2021-22 was still a profitable year. The same study, if done for 2022-23, would render much worse results,” says Sunil Damania, chief Investment officer, MojoPMS, a portfolio management services firm.

Yoga relief

Even when retail traders lose, they don’t concede defeat easily. This leads to a cycle of more losses.

Take the case of Mumbai-based Abhijit Agarwal, a 42-year-old working with a multinational. He started trading early in 2018 and earned a profit every month till June. In July 2018, he lost all the money he made when he bought call options of YES Bank. “I bet on the stock rising and it kept falling. I had no idea about how to hedge my naked positions,” he says.

Post the pandemic, he bought put options in PVR Cinemas thinking the company would make losses. He also shorted Reliance Industries Ltd and Indraprastha Gas Ltd as nobody was driving on roads. “All of these stocks kept going up against my expectations. I lost a substantial amount. In fact, I lost ₹4-5 lakh several times in stock and Nifty options,” he says.

Agarwal would wake up in the middle of night to check the performance of global markets. He would start walking around the home frantically all tensed up. His family—parents, wife, and even his 10-year-old son— advised him to stay away from trading.

“I had spent so much time in the market. I studied so many books. I couldn’t have done anything else,” he says. He still trades in F&Os and does Iyengar yoga to keep himself calm.

Over time, Agarwal learnt risk-mitigation strategies. His aim now is to earn 2-3% each month through trading.

Then, there is Rajashree Mukherjee, a 34-year-old. He started trading with a capital of about ₹2 lakh. “You make a few wins and you realize it’s quick money. Then you go all in. One day, I lost ₹1 lakh in a day in F&O. That was difficult to cope with. I couldn’t tell my family or friends,” he says.

Next, he put in more money, desperately wanting to make a profit. “I lost over ₹7 lakh in a span of two years. April 2020 was a big setback,” he remembers.

Collective greed

Why do people get sucked into this cycle of losses? A simple answer is greed.

The entire ecosystem fuels this greed. Every business television channel covers derivatives and intraday trading quite extensively.

Deepak Jasani, head of Retail Research at HDFC Securities, a brokerage, says many retail investors get easily influenced by the electronic media or finfluencers and jump into F&O trading. “They don’t spend enough time to build the required skills and money management discipline for such a high-risk product, and end up losing money. They dabble in F&O like a lottery, quite often on the expiry day, by buying contracts that are way out of money and whose premiums are cheap,” he says.

Not only is F&O trading easily accessible with an influx of mobile-based trading platforms, traders do not need a huge amount of capital to go ahead with it. A report by Axis Mutual Fund pointed out that the premium costs of options have reduced significantly after the launch of contracts with weekly expiries. Earlier, options had monthly expiries which had higher premium costs.

Deep study

Aniket Nerkar’s case illustrates the need for acquiring the right knowledge and expertise before one can comfortably dabble in derivatives.

The 28-year-old, also based in Mumbai, tasted trading early in life—when he was in standard X. He started trading using technical analysis, analysing chart patterns and technical indicators.

Nerkar informed his family in 2014 that he planned to take up trading as a full-time career. His father, a government employee, was initially reluctant. It took some convincing but Nerkar finally got him on board. He enrolled himself in a course at the Bombay Stock Exchange (BSE), which he did along with his B.Com graduation course.

Nerkar had an early setback. In 2015, he lost almost the entire trading capital of ₹2.25 lakh. Worse, his initial capital came through his mother’s shares. He says he was completely lost at that point and started questioning his career choice.

Nerkar, however, re-entered the market after a year when weekly option contracts were introduced. He built a strategy on an excel spreadsheet and back-tested it. He showed it to his professor at the BSE, who also thought the strategy was sound.

“There was an opportunity to make easy gains as when weekly option contracts started, nobody still knew how to price them,” he says.

His strategy worked so well that he even started managing money for friends. However, he needed a licence from Sebi to continue doing this. Sebi officials suggested that he needed more experience, and a postgraduate degree. So, he pursued a postgraduate diploma in quantitative finance from the National Institute of Securities Markets, an institute that focuses on capacity building for the securities markets. Nerkar is now a Sebi-registered research analyst, offering quant-based strategies to traders. He believes trading in F&O requires patience, discipline and years of deep study.

Fight in a second

There is a need for deep study because, like we mentioned earlier, derivatives trading is a high-risk game. Sebi’s report stated that 90% of the traders lost money. So, what did the rest of the 10% do to earn it?

Michael Lewis, author of Flash Boys, published in 2014, said that the stock market is “rigged” in favour of high-frequency traders (HFT), who use sophisticated computer algorithms to execute orders at very fast speeds. Their systems are so advanced that they can capture even one or two-point difference in the share price to make humongous profit. “The time advantage of a high-frequency trader is so small, it’s literally a millisecond. It takes 100 milliseconds to blink your eye, so it’s a fraction of a blink of an eye, but that for a computer is plenty of time,” writes Lewis in the book.

While Lewis’ context was the Wall Street, HFT is very much in vogue in India and is often called ‘algo trading’ in common parlance. HFT firms place their servers in the premises of a stock exchange (called co-location) so that they can get the market data seconds earlier than the others. Data from the National Stock Exchange (NSE) shows that more than half of equity derivatives trading—55.34% as on September 2023—takes place through algo and co-location.

“Retail traders have also started selling options with the help of quant-based algo strategies to improve their chances of making money, but they need to keep in mind that when it comes to option selling, they are competing with institutional traders and HFTs with far more sophisticated infrastructure,” says Rishi Kohli, managing partner and chief investment officer (hedge fund strategies), InCred Alternative Investments.

Data from the NSE shows that co-location charges are among the top three revenue drivers for the stock exchange. The exchange earned ₹613 crore from the same in 2022-23, compared to ₹433 crore in 2021-22. It is safe to assume that algo firms, collectively, earn far higher than their annual co-location charges.

Sebi’s to-do list

So, what can Sebi do to prevent F&O losses by retail traders?

The regulator needs to tackle the primary cause—the dissemination of F&O misinformation on electronic and social media.

“Brokers make money by pushing daily trades to retail traders. If they don’t do it, they will be out of business. Out of ₹100 that a brokerage makes, ₹80-85 comes from F&O and the balance from the cash segment. Sebi needs to ensure that their compliance cost is reduced and their business model becomes viable,” Damania says.

Brokers earn a brokerage fee on every order the investor places when buying or selling in the F&O segment. To be sure, most brokers are now offering extremely competitive rates, which range from ₹15-20 per executed order.

Moreover, TV channels and online platforms need to clearly highlight that F&O is addictive and can lead to heavy financial loss. “The advertising rules should be in line with how they are for gaming platforms. Ironically, chances of losses in F&Os are higher than in online gaming,” he says.