There's no future in Futures & Options

A recent SEBI study revealed that nine out of 10 traders incurred losses in futures and options (F&O). On average, an individual trader lost Rs 82,500 in 2022.

For the uninitiated, futures and options (F&O) are derivatives traded on the stock exchanges that derive their value from underlying assets like shares and commodities.

Despite the alarming statistics, numerous retail investors are still attracted to futures and options. It's not entirely their fault. When presented with alluring returns in a glossy and glamorous manner, it's no surprise that F&O trading manages to captivate investors.

So, before you decide to lose your hard earned money, let's understand why F&O is risky and why staying away from it is a better idea for an investor.

Complex pricing

Unlike stocks, where price movement is more straightforward, F&O pricing is complex and a function of multiple variables, such as the volatility of the stock, time till expiry, strike price, discount rate, and current stock price.

For example, as can be seen in the table, while the price of Reliance Industries increased by 7.34 per cent, the price of its derivative appreciated by a whopping 300 per cent in the same time period.

Additionally, F&O pricing is often swayed not solely by fundamentals but by market frenzy and knee-jerk reactions. External elements like market sentiment, speculation, and sudden market reactions can contribute to occasional irrational price fluctuations in the derivatives market, more so than in the stock market.

As can be seen in the table, on December 21, 2023, when the Nifty 50 dropped to Rs 20,977 due to FII selling, the price of its derivative (put option) spiked seven times in a single day.

So, if you claim to be a market soothsayer and can predict stock prices, remember that figuring out how the prices of derivatives will move is even harder.

Unscrupulous business model

Derivatives serve as the lifeblood of brokers, constituting a vital aspect of their business model. The industry's primary goal is to boost derivatives trading volumes, with participants actively steering clients toward F&O.

On prominent online brokerage platforms, generally a flat fee of Rs 20 is levied for each executed derivative trade. Zero brokerage is charged for equity trades. This is a testimony that brokers' profitability is intricately linked to the overall volume of derivatives trades.

Further, SEBI, in its report, has highlighted that transaction cost as a percentage of total net trading profit was 15 per cent in FY22 and transaction cost as a percentage of total net trading loss made by loss makers was 23 per cent in FY22. This shows that frequent trading resulted in higher transaction costs.

Possibility of a margin call

In derivative trading, if the price of a stock moves unfavourably and the value of your position declines, the broker may issue a 'margin call'. This requires depositing additional funds into your trading account to cover potential losses.

For example, Reliance Industries futures are priced at Rs 2,555 with a lot size of 250, making the total value Rs 6,38,750 (Rs 2,555 x 250). If the maintenance margin is set at 10 per cent, which is Rs 63,875, and your trading account balance drops below this threshold due to losses within your specified time frame, the broker will issue a margin call.

Failure to deposit additional money into the trading account could lead the broker to close out your trades to mitigate potential losses. This risk of forced liquidation due to unfavourable price movements in between the time horizon is a key consideration which is often overlooked.

Our word

The F&O segment appears lucrative for high returns, but it operates as a zero-sum game . Unlike equities, where everyone benefits from a company's growth, F&O profits come at the expense of others' losses, creating a scenario where your gain relies on someone else's loss.

Given this, we recommend avoiding F&O. And the recent SEBI study reinforces that this segment is where investors incur the most losses.

Also read: Derivative delusion