Decoding SEBIs F & O Revamp: A Step Towards Investor Protection

By Vanshika Gupta

Background 

Over recent years, the Indian equity index derivatives market has experienced significant growth, driven primarily by the increasing participation of retail investors. This rise in retail involvement has coincided with the introduction and rapid expansion of weekly options contracts, first launched by NSE in 2016 for sectoral indices, and later extended to benchmark indices in 2019. By 2023, these weekly contracts were available across all five trading days, resulting in a market environment where speculative trading, especially on expiry days, became increasingly prominent.[1] 

To put it in perspective, on any given expiry day, up to 27% of the daily turnover for indices like SENSEX happened in just the last 30 minutes of trading. This is because options prices tend to collapse near expiry, turning them into cheap, high-risk bets. Many traders treat these moments as last-ditch opportunities to make quick profits, but the reality is quite different. SEBI’s 2023 study painted a sobering picture—9 out of 10 retail traders in the equity derivatives market ended up losing money.[2] In FY24 alone, retail traders lost a staggering ₹51,689 crore, with nearly 85% of them walking away with net losses. The few who did make profits were usually those using algorithmic or systematic trading strategies, not the average retail investor trying to time the market with risky trades.[3] The combination of hyperactive trading on expiry days, high leverage from options trading, and increased volatility near expiries led SEBI to recognize the need for comprehensive regulatory reforms.

In light of these trends, SEBI recognized the urgent need to implement regulatory measures, SEBI introduced a consultation paper aimed at implementing measures to safeguard retail investors and enhance market stability in the equity derivatives segment. As a result, SEBI has recently introduced six key amendments designed to improve the functioning of the Futures and Options (F&O) market, with a focus to protect retail investors. This blog aims to discuss these amendments and its likely implications on the stock market. 

Increase in the Contract size for Index Derivatives 

As per SEBI Guidelines, the contract size for index derivatives has been pegged between ₹5-10 lakhs since 2015. However, given the significant growth in the Indian stock markets and increasing participation, SEBI through this amendment has raised the contract size of such index derivatives to ₹15-20 lakhs with the aim to align contract sizes with the larger market valuations while ensuring more responsible participation in the Futures and Options (F&O) segment, particularly by retail investors.

SEBI with the introduction of this, aims to create a suitability filter, ensuring that only those with sufficient capital and risk tolerance participate in these high-risk instruments. This is aimed at curbing excessive speculation by small retail investors, many of whom may not fully understand the risks associated with leveraged trading. 

However, in reality while raising the contract size in index derivatives could curb speculative behavior, retail investors might seek alternative ways to achieve similar leverage, such as trading in smaller stock derivatives or using leveraged ETFs. This could shift risk-taking to other market segments, rather than eliminating it. Additionally, considering the current market scenario, this increase in contract size may encourage buyers to engage in higher-risk trading strategies, as they may feel compelled to seek greater returns on their larger investments, thus exposing themselves to heightened risks in the F&O market.

Reduction of weekly expiration of Index derivative products 

Secondly, SEBI has introduced a limit to the number of weekly index derivative products expiring per week to one per exchange. This initiative aims to diminish the previously observed high trading volumes and market speculation, particularly prevalent on the expiry days, thereby mitigating losses incurred by retail investors. As explained above, previously, traders faced multiple expirations throughout the week, which often led to chaotic trading as investors rushed to adjust their positions across various contracts. With the new structure, for example, if the NSE’s Nifty Midcap expires on Monday and the BSE Sensex on Friday, it allows traders to focus their strategies on one contract at a time. Therefore, instead of operating under a D0 (zero days to expiry) format, this proposal promotes a D1 (one day to expiry) framework which encourages more uniform and disciplined trading practices.

Eliminating the calendar spreads strategy treatment for expiry days 

To better understand this amendment, let us first decode what is meant by a calendar spread strategy. A Calendar spread strategy in the F& O market involves simultaneously buying and selling futures or options contracts with the same underlying asset but with different expiration dates. This helps the investors/traders to enjoy a calendar spread margin. This means that the premium (price) one pays for the longer-term contract (derivative contract bought at a later date) is partially offset by the premium one receives for selling the shorter-term contract (derivative contract bought at an earlier date). This effectively reduces the overall capital outlay compared to purchasing a single long option or futures outright. 

SEBI through its amendments is aiming to remove this calendar spread margin benefit on expiry day. This has been introduced because the high volumes of trades experienced during the expiry periods of the index derivatives creates a basis risk, which means a situation where the value of expiring contracts diverges markedly from the value of contracts with future expiries. This heightened trading activity often leads to discrepancies in pricing, especially as traders look to close out or adjust their positions in response to market fluctuations. By eliminating the margin benefits associated with calendar spreads on these days, SEBI aims to reduce the potential for speculative trades that are primarily motivated by margin considerations rather than sound trading strategies.

Intraday Monitoring of the position limits by exchanges 

Additionally, SEBI has introduced monitoring of the position limits by exchanges from an end of session approach to an intra-day monitoring system so that any undetected positions that exceed the position limits during the day cannot go unnoticed due to the large volumes being experienced. This enables SEBI to ensure real-time monitoring, preventing traders from holding excessive positions during the day.

Upfront collection of Option Premium from options buyers 

SEBI in its consultation paper noted that the prices of Options can experience rapid price appreciation or depreciation due to their non-linear nature, leading to a high implicit leverage. This creates a potential for significant gains or losses within a short period. SEBI, through this amendment has proposed to collect an upfront option premium from option buyers to prevent any undue intraday leverage to the end client so that that buyers cover their positions from the start.

Currently, some brokers allow traders to use leverage through cover orders or by providing collateral, such as stocks, to meet margin requirements instead of paying the full premium upfront. This practice enables traders to take larger positions with relatively low capital outlay, increasing their potential exposure in the market. While this can amplify returns, it also significantly amplifies risk, particularly for retail investors who may not fully understand the implications of such leverage. This amendment aims to reduce speculative trading, as retail investors will need more liquid capital to trade, limiting their ability to take larger positions with minimal upfront cost.

Increasing the ELM (Tail risk coverage) on day of expiry of options 

The current rate at which the extreme loss margin (ELM) is charged on index derivatives is 2% on the notional value of such instrument. This is used as a risk mitigation instrument which is designed to provide a buffer against unexpected and significant price fluctuations in the underlying asset. Due to the high risk and leverage in the market on before the day of expiry and during the expiry days of the index derivative, SEBI in its consultation paper proposed to introduce an additional 3% ELM on the day before expiry and a further increase of 5% of ELM on the expiry day. However, in its amendment SEBI has introduced a 2% additional ELM on short option contracts expiring at the beginning or options initiated during the expiry date. The additional ELM will require traders to allocate more capital for margin requirements, potentially limiting their available funds for other trades and prompting more cautious strategies, which may lead to reduced selling activity and lower liquidity in the market as sellers become more conservative in their trading approaches.

Conclusion 

In conclusion, SEBI’s amendments are expected to significantly curb speculative volume-driven trading, especially with the reduction of weekly index expirations to one per exchange. This will likely reduce liquidity and trading volumes, adversely impacting brokers who rely on high turnover. While brokers may experience operational challenges, SEBI’s focus on intraday position monitoring and upfront premium collection will foster a more disciplined and stable market. These measures are essential to ensure investor protection, reduce excessive speculation, and promote sustainable, long-term market practices. However, the true impact of these amendments on the F& O segment will only become evident with their implementation in the future, which will be a crucial aspect to watch.

[1] SEBI - Consultation Paper on Measures to strengthen index derivatives framework for increased Investor protection and Market stability

[2] The Rise and Risks of India’s Derivatives Market, Financial Express, October 8, 2024 https://www.financialexpress.com/market/cafeinvest-the-rise-and-risks-of-indias-derivatives-market-3634211/

[3] Supra 1

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.