Small Investors and the Risk of Derivatives

India was introduced to Derivatives in Exchanges in 1999. A lot of water has flown since then in terms of the stocks, their contract sizes among others. What hasn’t much changed is the fact that we were and always have been a cash settled derivative exchange (one of the very few).

India has one of the most myriad of laws, most of which are to protect the weak and the innocent. Derivatives aren’t instruments that are suitable to everyone. Nick Leeson working at Barings Bank at Singapore had a mandate to look out and trade Arbitrage opportunities he spotted on the Nikkei 225.

To cut a long story short (if you are interested, do read Rogue Trader, one hell of a good book), he was able to bring down a 200 year old bank that had survived through thick and thin sitting from his small office in Singapore.

The Parliamentary Standing Committee on Finance in 1999 observed that because of the swift movement of funds and technical complexities involved in derivatives transactions, there is a need to protect small investors who may be lured by the sheer speculative gains by venturing into futures and options.

SEBI’s mandate is to safeguard the small investor from harm (both self inflicted and one inflicted by other participants). Based on the committee report, SEBI decided to keep a threshold limit of Rs.2 Lakhs as minimum contract size.Recently this was raised to Rs.5 Lakhs as minimum.

But like ants get attracted to honey, small investors have got attracted to options. If attraction wasn’t enough, NSE in its wisdom introduced Weekly options in Bank Nifty.

Option Prices depend on 3 factors (more or less). One is “Intrinsic Value”, second is the amount of time left in the Option and third is Volatility.

The longer the period of time left before the option expires, the more expensive the option is (again, this is dependent on a host of other factors including Strike, but lets keep it simple and say for a option at the current level / price).

But as it comes closer and closer to expiry, options can get pretty cheap and on the last day, all bets are off as options can really move (if the underlying moves).

Take for example, the Expiry day of May – 25th May 2017. Here is how much some options moved that day (calculated from the low of the day to the day’s close).

For anyone who was long that day and held till close, it was a jackpot like no other. Any wonder that small investors get lured by option tip sellers showcasing one such instance to showcase how easy its to make money on options.

The other day, I came across the tweet of one Mr.Aftab Khan who got caught with positions which were In the Money at the time of Expiry and was expected to pay Rs.6,25,942/- as Security Transaction Tax. Lot of people believe this is unfair. Petitions have been signed to see to it that option expiry isn’t treated as Exercise (Exercise in reality is when you exchange your option for Shares in American Style Options).

If you are new to Options, do read “Options Exercise, Assignment And Settlement” to understand what this is all about.

So, how did the Trader get into a situation where he has to pay as STT more money than he spent on Options?

The answer to that question comes by calculating his Exposure (Notional Value). The trader bought or held at time of Expiry, 20,960 Call Options of Bank Nifty with Strike Price of 23,900. The average buying price was 1.14 which means he paid a sum of Rs.1.14 * 20,960 = 23,900 to acquire total contracts with a Notional Value of Rs.50,09,44,000 (Fifty Crores).

STT when options are closed via Exercise are charged at a different rate than when closed intra-day and there-in lies the problem. If Options were closed intra-day, the STT charged is only on Premium (used to be Premium + Strike for many years till it was changed in June 2008).

But STT is not a issue given that this is a issue that is known from a very long time with only new investors falling for the trap once in a while. The bigger question is, should small investors even be allowed to take trades that are larger (in Notional Terms) than the Networth of many brokers.

In a Moneylife Article (Link), the issue of Systematic Risk is raised and I agree. Small brokers can be doomed with just one or two such clients. While the client may eventually pay, if he isn’t able to pay immediately, the broker needs to make good and if he fails, he will be suspended and all his monies frozen by the Exchanges.

While its agreeable that STT needs to be changed when there is a financial closure rather than closure via exchange of stock (which can never happen in a Index option), the key to avoiding such heart burns is to ensure that small investors aren’t allowed to trade.

The reason for contract size being Rs.5 Lakh was supposedly to ensure that small clients don’t get trapped and yet, here we are.

In the United States of America, Securities and Exchange Commission (our equivalent of SEBI) has regulations that require that the trader maintains an equity balance of at least $25,000 into their trading account to be allowed to trade Intra-day.

Even in India, a small investor cannot invest in a PMS without he putting up a minimum of Rs.25 Lakhs, cannot invest in a Hedge Fund unless he can puny up a minimum of Rs.1 Crore. The reason is said to be that both these are sophisticated instruments and hence shouldn’t be offered to smaller investors who can lose their hard earned savings. Yet, Derivatives seem no sophisticated enough to ensure a minimum investment / networth requirement for now.

Its time SEBI comes up with similar minimum investment requirements for Derivatives (Rs.10,Lakhs of Equity (Cash or Stock) Balance for example) to ensure that small investors inadvertently don’t get caught.

Of course, there will be the argument that this will just push investors determined to trade in Derivatives into the illegal (Dabba Trading for example). But if some one is intent on doing something against the law, no amount of law can really stop him.

Helmets are compulsory in Bangalore and yet every other day, there is a news paper article about some death in a accident due to non wearing of a Helmet. Karnataka banned Lottery tickets (which was a large Industry) and had to suffer a blow-back in terms of Revenue. But this has also meant that people who weren’t addicted were saved from losing their savings. But is Lottery really gone? Of course not, especially now with access to online gambling, but most daily wagers aren’t really that versatile.

I have been trading Options on and off since 1999. While its easy to blame Exchanges / SEBI for greed, I believe the real jump up in volumes (from small investors) have come thanks to Discount Brokerages. In the hey days before Discount Broking, I would have paid 50K as Brokerage (one side) for buying so many contracts. These days, you could have bought them all by paying just Rs.20 (A reduction of 99.96%).

Low brokerage is a incentive to trade more. While our Exchanges lack the depth seen in other more mature exchanges, NSE is the Number One among all Exchanges when it comes to Index Options.

SEBI recently released a Discussion paper on Growth and Development of Derivative Markets in India wherein one matter of Discussion is “Taking into account trading of individual investors in derivatives, especially options, is there a need to introduce a product suitability framework in our market”