Derivatives, though lucrative, are fraught with dangers. Investors must tread carefully
Legendary investor Warren Buffett believes that derivatives are “financial weapons of mass destruction”. “Derivatives time bomb” refers to a possible market deterioration if there is a sudden unwinding of derivatives positions. One cannot forget that the 2008 financial crisis was primarily caused by derivatives in the mortgage market.
A recent study by the Securities and Exchange Board of India (SEBI) confirms the above belief. SEBI has published a study paper on the Profit and Loss of Individual Traders dealing in the Equity Futures and Options segment. The objective of the study was to analyse the trading by individual investors concerning net profit/loss incurred by them in the equity F&O segment for the period FY 2019 and FY 2022.
Derivatives and their usage
As we know a derivative is a financial contract whose value is tied to an underlying asset and common derivatives include futures contracts and options. Derivatives should be used ideally to hedge against a position. For example, if one is holding a particular share, he can enter into a sale contract in the Futures market so that if the price of the share falls, he will be protected as he will be holding a sale position also in futures. But people use the derivatives for speculation or arbitrage. Persons who enter derivatives with the purpose of speculation may not have any position originally but just to have the price difference in the derivatives he buys and sells derivatives. Arbitrageurs may take advantage of differences in the price in the cash segment and derivatives segment.
Need to regulate speculation
While speculation in the share market is required to some extent, the market regulator has to ensure that it should be a healthy one. The market needs sufficient depth to provide liquidity and speculators provide such depth through their speculative activities. Hence it may not be wise to out-rightly ban speculative activities.
Of late we are witnessing that individual small investors are lured to participate in the derivatives segment with various incentives. The trading platform lures them with insignificant or no brokerage.
But now the study conducted by SEBI throws light on the extent of damage done to individual investors through the derivatives segment.
SEBI study reveals the mind boggling increase in the individual traders who participate in the segment. The total number of unique individual traders who traded through a sample of the top 10 brokers in the equity F&O segment was 45.2 lakhs during FY22, up from 7.1 lakhs during FY19 (a significant increase of over 500% in FY22 as compared to FY19), of which 88% were active traders.The study reveals how the younger generation has been lured to enter the derivatives market. During FY22, Individual traders belonging to the age group 30-40 years had the highest share in participation (39%) across all age groups. For younger individual traders (20-30 years), the percentage share of participation went up significantly from 11% during FY19 to 36% during FY22.
The study reveals that 89% of the individual traders (i.e. 9 out of 10 individual traders) in the equity F&O segment incurred losses, with an average loss of Rs.1.1 lakh during FY22, whereas, 90% of the active traders incurred average losses of Rs.1.25 lakh during the same period.
For the group of active traders (excluding outliers), on average, loss makers registered net trading losses close to Rs 50,000 in FY22. For the group of active traders (excluding outliers), the average loss of a loss maker was over 15 times the average profit by a profit maker during FY22.
During FY22, 11% of individual traders in the equity F&O segment made a profit with an average profit of Rs.1.5 lakhs. The percentage went down marginally to 10% for active traders, though the average profit made by them went up to Rs.1.9 lakh during the same period.
For the group of active traders (excluding outliers), only 6% of individual traders in the equity F&O segment made a profit with an average profit of nearly Rs.3,400 in FY22. The top 1 per cent and top 5 per cent active profit makers accounted for nearly 51% and 75% of the total net profit earned by all active profit makers, respectively.
One must understand that derivatives are basically for hedging and a recent study reveals that it is highly risky for individual investors to use them as a speculative tool to make money from the share market.
Entering a derivative position may be injurious to the financial health of small investors. One may be tempted to overtrade due to the leverage available in the derivatives market and such wide leveraged exposure increases the risk proportionately.
We have to wait and see how the regulator SEBI is going to take corrective measures to save the retail small investors.
(The author is a retired banker)