(Bloomberg) -- India has gone from being a small player in the equity derivatives market to the world’s largest, all within just five years. Most of the new demand is coming from inexperienced retail investors with an appetite for risk.
Annual turnover in the market is now greater than the entire output of Asia’s third-biggest economy. Dabbling in these options can land investors with big losses when bets go wrong. Regulators are increasingly concerned about the potential danger to financial stability, and India’s securities watchdog introduced a slew of steps in October to limit equity derivatives trading, attempting to shield retail investors whose appetite for the products fueled their rise.
What are equity options?
They provide investors with the choice, but not the obligation, to buy or sell a stock at a predetermined price and date. These instruments are useful for investors to hedge against risks in their stock portfolios.
There are also futures contracts, which oblige an investor to buy or sell a stock at a predetermined price on a specific future date, with no option to back out.
In India, these products have become a way to place speculative bets on moves in share prices without needing to put up large amounts of money. Investors only need to pay for the contract — sometimes costing as little as 10 rupees (12 US cents) — and they can take leveraged positions equivalent to as much as five times their invested capital.
If an investor expects a 5% rise in a stock, they might buy a call option, paying a small premium to the seller, who is often another retail investor. If the stock rises more than 5%, the first investor makes a profit. If it falls, their loss is limited to the premium paid. The major risk is to the seller: If the value of the underlying stock rises above the strike price, they incur a loss.
Why are equity options booming in India?
India’s futures and options turnover hit a record $6 trillion in February, soaring from less than $150 billion five years ago. A large part of this growth followed the introduction of weekly-expiring contracts in 2019, replacing the traditional month-end expirations.
There’s been a similar pattern in the US, where options trading surged following the introduction of even shorter, zero-day options.
The main advantage of shorter duration is that, because there’s less probability that their value will increase before expiration, there’s less chance that the seller will incur a loss, and therefore they cost less.
The introduction of these shorter-duration options has stoked trading volumes, benefiting both the National Stock Exchange of India and stock brokers.
Why have Indian retail investors gotten so involved?
The coronavirus pandemic spurred a surge in interest for these products as it left millions of people working from home, with extra time to spare and more money to invest. The spread of mobile trading apps, the ease of opening an account and the proliferation of how-to-trade content on social media fueled the frenzy.
The number of Indian retail investors trading options has gone from fewer than a million in 2019 to 4.5 million today. Many see options as a low-cost, fast way to speculate, especially with the value of India’s stock market trebling from its March 2020 lows.
Why are regulators worried?
India’s derivatives market grabbed global attention in April after US-based Jane Street Group disclosed that it had made a $1 billion profit from trades in the nation. India’s market regulator had already warned small investors that they were taking a big risk in trying to bet against larger, better-funded and more experienced financial market players.
An updated study released last month by the Securities and Exchange Board of India found that 93% of retail investors had lost money on derivatives in the three-year period ended March. The regulator also quantified those losses: As much as $7.3 billion was lost in the fiscal year ended in March.
What are regulators doing to curb the boom?
The measures from SEBI that come into effect in November erect hurdles for short-term speculative bets, such as limiting index option contracts with weekly expiries, according to the details on its website. The regulator blamed these products — first introduced in 2019 by the National Stock Exchange of India Ltd. — for the “hyperactive trading” and “increased volatility” seen on expiry days.
Additionally, brokers are required to collect larger margin payments from people selling options contracts on their expiry day under the new measures.
Separately, the government raised taxes on short-term trading profits from equities for the first time in 15 years and doubled the transaction tax on futures and options trading.
Who could be the winners and losers?
Market strategists estimate at least a third of equity options volume will evaporate after the new rules take effect. This would sharply erode revenue for stock exchanges, particularly the NSE, which has been buoyed by short-duration options. Some global high-frequency firms and domestic trading funds are also expected to suffer higher trading costs, squeezing their profit margins and making it less appealing to allocate capital to Indian markets.
--With assistance from Jon Herskovitz.
©2024 Bloomberg L.P.
