Futures & Options Frenzy: Retail Investors Suffer as SEBI Plans Rescue

Rising Losses and Increasing Retail Participation

India’s retail investors have been reeling from massive losses in the derivatves market (Futures and Options, F&O), with a staggering INR 1.81tn (USD 21.67bn) in net losses over the last three fiscal years from FY22 to FY24, according to a recent study by the Securities and Exchange Board of India (SEBI). The study found that 93% of over 10m individual F&O traders recorded average losses of approximately INR 200,000 each during this period, highlighting the risks posed by the growing popularity of derivatives trading among retail participants.

The study revealed a sharp increase in retail losses in FY24 (April-March), with 91.1% of retail traders losing money in the derivatives segment, resulting in gross losses of INR 524bn. This increase in loss-making retail investors, up from 89% in FY22, demonstrates a concerning trend as more retail traders enter the market. Notably, retail participation has grown, particularly among younger traders, with 43% of retail participants in FY24 being below 30 years old. Most of these traders come from lower-income brackets, earning less than INR 500,000 annually, further exacerbating the financial impact of their trading losses.

Algorithmic Trading Dominates Profits

While retail investors struggle, proprietary traders and foreign investors have profited significantly from derivatives trading. According to SEBI's data, proprietary traders recorded gross profits of INR 330bn, and foreign investors made INR 280bne in the same period. Notably, these profits were largely driven by algorithmic trading, with 97% of foreign investors' profits and 96% of proprietary traders' profits stemming from algorithm-driven strategies. The disparity between retail losses and institutional profits highlights the challenges individual investors face in competing with larger entities that use advanced trading tools and algorithms.

SEBI’s Response: Potential Reforms Ahead

In light of the heavy losses sustained by retail investors, SEBI is expected to introduce measures aimed at enhancing investor protection in the F&O segment. Among the proposed changes are tighter regulations for index derivatives, including revising the minimum contract size, introducing upfront collection of option premiums, and enhancing intra-day position monitoring. The regulator has also suggested raising the minimum contract size in two phases: initially increasing it to INR 1.5-2mn, with a further increase to INR 2-3mn after six months. The current minimum contract size of INR 500,000-1m was set in 2015, and SEBI believes an upward revision could help curb excessive speculation and reduce the number of retail traders taking on undue risk.

Other potential reforms include rationalising strike prices, removing calendar spread benefits on expiry days, and increasing margins on contracts nearing expiry. These measures are designed to improve risk management and transparency in the derivatives market, making it less prone to speculative excesses that have been driving retail losses.

Call for Stricter Regulation Amidst Pushback

While SEBI’s proposed changes aim to safeguard retail investors, they are likely to face resistance from some market participants. The F&O segment, particularly options trading with weekly expirations, has become highly popular among traders seeking short-term gains, despite the inherent risks. Many retail traders use derivatives for speculative bets, which have led to the mounting losses highlighted in SEBI’s study. In response to the growing risks, SEBI has raised the possibility of further limiting the number of weekly expiration options and imposing stricter entry barriers for retail investors. However, these measures may meet opposition from investors accustomed to the flexibility and potential for quick profits that weekly expirations offer.

SEBI’s Broader Market Reforms

Beyond the F&O segment, SEBI has been active in rolling out broader reforms to strengthen India's capital markets. While no immediate changes were announced regarding F&O trading during SEBI’s recent board meeting, the regulator approved several important measures, including the introduction of new asset classes for high-net-worth individuals, "MF Lite" regulations aimed at simplifying mutual fund investments, and a reduced timeline for rights issues. 

Another key initiative SEBI is advocating for is tax breaks on municipal bonds, which are crucial for funding infrastructure projects. SEBI plans to make a case for these tax incentives in its upcoming discussions with the Finance Commission.