Bidding Goodbye To Blind Bets: SEBI’s Reforms In The F&O Market

By Suhana

Introduction

Recently, on October 1st 2024, the Securities and Exchange Board of India (SEBI) introduced new guidelines addressing Futures & Options (F&O) trading, effective for all index derivatives post November 20, 2024; to minimize risks and foster efficiency. Two very common financial derivatives in the trading market: futures and options permit the investors to either buy or sell securities at a predetermined price and date, hedging against market risks. In a futures contract, an individual agrees to purchase or vend an asset, like a stock or commodity, at a fixed price on a specific date in the future. Both parties must stick to the deal, whether the price goes up or down. On the other hand, an options contract only gives an individual the “right not the obligation to buy or sell an asset” at a fixed price and date. Their economic importance lies in their potential to enhance liquidity, stabilize prices, and provide protection against volatility, making them integral to the functioning of global financial markets. With the coming of the reforms, this article provides a detailed analysis of the reforms introduced by SEBI, examining their scope and implications. It delves into the rationale behind these changes and critically evaluates whether there was a genuine need for such reforms, considering their potential impact on the market and stakeholders.

A Step Forward or A Leap of Faith: Reforms in the F&O Market

India was witnessing a  rise in loss-making investors in the F&O market from 89% in 2022 to 91.1% in 2024. Not only this, 93% investors faced an average loss of Rs 2 lakh during the last three years which can be attributed to three main factors. Firstly, inadequate risk management exerted a negative impact on the overall financial well-being of the investors. Contracts pertaining to less popular stocks and far-out expiries make it difficult for investors to enter and exit positions without influencing the price. There is lack of proper expertise regarding position size in the market which refers to determining how much money to put in which investment or trade opportunity. If a market is not working in favor of an investor, he might need some additional margin, failure of which can force him to close his position at loss. Despite the clear housing function in exchanges, there is a slight chance of the other party to default on its part especially in over-the-counter derivatives. However, there is no robust framework to address the aforesaid risks in India. Secondly, the psychological element of traders increases susceptibility to losses encompassing overestimation of one’s own skill, overtrading by investors who succumb to the temptation of more profits, and representative heuristic leading them to make decisions based on similar prototype. Thirdly, unanticipated but crucial events which have the ability to trigger a cycle of changes in the economy, often known as “black swan events”, have the ability to disrupt the financial market increasing its volatility. A recent example of such an event was the COVID-19 crisis which led to the hampering of India’s stock indices: Sensex and Nifty. Sentiments of the stock market were miserable due to the apprehension of the effects COVID-19 could have reaped in the future. Currently, India has no specific guidelines or legislation which provides for preventive measures which traders or individuals could adopt to lessen the effects of such shocks in the economy.

After a cross-border analysis, it can be concluded that other countries like the US offer a more comprehensive regulatory mechanism for the F&O market. According to the rules of the Securities Exchange Commission (SEC), a trading official is appointed who is an OTP holder with the authority to recommend and enforce regulations for trading access, decorum and welfare of the Options Trading Floor. The Financial Industry Regulatory Authority undertakes the responsibility to educate general public about investments, frauds, and risk management. Furthermore, it mandates all the companies involved in securities-related transactions to register with itself in order to become a “licensed broker dealer.” The Commodity Futures Trading Commission has a separate whistleblower program under which it provides monetary incentives to those who report the infringement of the Commodity Exchange Act while maintaining their privacy. One more example of better transparency and consonance with the general practice in equity and futures market is the FIFO rule: first-in, first-out. Under this, a dealer can’t hold multiple positions in the same currency, so he must close the earlier trades first. For instance, if an investor buys 100 shares of a stock at Rs 20 and buys another 100 shares at Rs 25, and he decides to sell 100 shares, the FIFO method would attribute the sale to the shares bought at Rs 20. Price adjustments under executed customer orders are prohibited but they can be done in issues beyond a customer’s control like problems with third party vendors. With a stricter regime followed by the China Securities Regulatory Commission and the Shanghai Stock Exchange launching stock index futures, regulatory policies in China also put more emphasis on the connection between real economy and the derivative market. This is done by tightening over-the-counter derivatives especially those decoupled with real economy.

Thus, the aforesaid paragraph itself explains that India is lagging behind in the derivatives regulatory framework and hence, there is indeed a dire need to introduce reforms in the F&O segment.

A Strategic Review of the Reforms

Earlier, traders were given the option to pay the premium amount at the end of the trading day but SEBI has now mandated the upfront collection of premiums from option buyers. By doing so, SEBI has tried to ensure that only those traders with sufficient resources engage in options trading making it more capital-intensive and less speculative. Secondly, SEBI has removed the “Calendar Spread Treatment” on contract expiry day. Prior to this, traders were allowed to take positions in contracts with different expiry dates, hence benefitting from margins offsets. By eliminating these offsets, the cost for traders to hold speculative positions without enough margins has been increased, promoting more disciplined trading. Not only this, open positions of traders will be now monitored during the day in contrast to them being checked at the end of day eliminating their leeway to accumulate excessive risk potentially leading to losses. With retail traders casually overexposing themselves to the derivative market with no substantive risk tolerance, SEBI decided to increase the minimum contract size for index derivatives. This refers to the required minimum value of a new index derivative contract for its launch in the market which, as of now, is Rs 15 lakhs. As a result, retail traders with less know-how and capital about the working of the derivatives market have less incentive to indulge in the same, making it less accessible. Thirdly, the restriction of weekly index expirations to a single occurrence per exchange by SEBI intends to minimize the speculative trading and market volatility. This reduction is expected to encourage traders to engage in long-term strategies instead of frequent short-term speculative activities. There are also strategies or measures which are designed to protect traders against extreme market events, known as tail risk coverage, which lie at the “tail” ends of the probability distribution- unlikely but events with severe consequences. They are similar to the black swan events which were discussed earlier. They involve drastic changes beyond the typical market fluctuations. To ensure that traders can withstand this type of sudden risk, SEBI has mandated them to maintain higher capital reserves during periods of heightened risk, for instance options expiry dates. This serves as a preventive measure for those who lack resources or experience to navigate sharp price movements effectively.

Conclusion

With an increasing number of retail traders participating in the F&O market, often without adequate risk management or experience, the need for these reforms has become more pressing. By addressing concerns such as speculative trading, inadequate capital reserves, and the lack of sufficient risk controls, SEBI aims to create a more disciplined trading environment that prioritizes investor protection and market stability. While these reforms may reduce accessibility for less experienced retail traders, they will definitely reap results necessary for growth in the long-term health of the F&O market. They reflect a broader effort to elevate the market’s overall standards and bring it in line with best practices observed in more mature financial markets. As India’s financial markets continue to evolve, these reforms will not only protect individual investors but also contribute to the broader goal of making the country a more attractive and competitive destination for global investment. These reforms ensure that the F&O market can grow sustainably, with fewer disruptions and greater long-term benefits for both the economy and its participants. The benefits certainly outweigh the short-term challenges, leading to a more robust, transparent, and resilient derivatives market in India.

Disclaimer

The views expressed in this article are solely those of the author(s). This article is intended for educational/information purposes only. The source of this article is publicly available information and under no circumstances should the contents of the article be construed to be professional advice by the authors.