How futures and options became India’s favourite game: Lessons from the Soviet Union

In fact, this anecdotal experience can be seen in data as well. As the stock brokerage ICICI Direct pointed out in a recent note: “India's monthly futures and options turnover reached a record… $1.1 trillion in March 2024. This phenomenal surge represents a significant jump from just… approximately $27 billion… in March 2019."

Given this, the average daily turnover in the futures and options segment of the stock market is now many times more than that in the cash segment. In simple English, this means that the number of daily transactions where investors are buying and selling stock futures and options are much more than investors buying and selling actual stocks. So the derivatives that derive their value from stocks have become much more popular than stocks.

In fact, even this does not tell us the gravity of the situation. As ICICI Direct further pointed out: “Looking at the recent month (April 2024), the combined volume of BSE and the National Stock Exchange [the two major stock exchanges in India] was nearly 81% of the global equity derivatives turnover." In fact, “84% of all equity options traded globally in the first quarter of 2024 were on Indian exchanges, a significant jump from just 15% a decade earlier".

This is the level of madness that is currently on. We have turned into a nation of futures and options traders.

Not surprisingly, this has got the Securities and Exchange Board of India, the Reserve Bank of India and the ministry of finance, all worried. Sebi, the stock market regulator, is trying to rein in this massive craze to trade futures and options.

Data froma Sebi report released in January 2023 pointed out that “89% of the individual traders (i.e., 9 out of 10 individual traders) in equity futures and options segment incurred losses, with an average loss of ₹1.1 lakh during FY22, whereas, 90% of the active traders incurred average losses of ₹1.25 lakh during the same period". Further, “for the group of active traders (excluding outliers), on average, loss makers registered net trading loss close to ₹50,000 in FY22… The average loss of a loss maker was over 15 times the average profit by a profit maker".

There are two points that arise here. First, the stock futures and options market is now much bigger than it was in 2021-22, with more individual traders being a part of it. Second, while Sebi has not released more recent data of this kind, given that it is worried and is taking steps to rein in the trading, tells us that the broader numbers probably continue to be along the same lines, if not worse.

The question is what can be done? But before we get into that, it’s important to realise why we are where we are. Cheap smartphones and even cheaper bandwidth, along with newer apps with simpler interfaces, have made trading in futures and options much easier than it was in the past. But there’s more to it than just this.

Now, there are three players—the stock exchange, the stock broker, and the retail investor—involved in this trading game. The stock exchange (BSE or NSE) charges the broker a transaction fee. This fee is based on the turnover that a stock broker contributes to the exchange during the course of a month. The higher the turnover the lower the fee.

Just because the exchange has dangled the carrot of a higher volume leading to a lower transaction fee doesn’t mean that the retail investors will start trading more and that the stock broker will get a higher volume of trading, and thus a lower transaction fee will have to paid to the stock exchange.

So, how does that happen? The stock broker has to drive up the volumes. Other than charging the investors a transaction fee, the stock broker also charges a brokerage fee to the investors to trade. This brokerage fee is the more visible fee.

The brokerage fee charged on the futures and options transactions has been made very low or zero. This point has been driven home over and over again through advertising and social media. The lower or zero brokerage fee encourages investors to trade more, and in the process, drives up higher volumes for the stockbroker, helping them pay the exchange a lower transaction fee.

Further, even brokers who claim not to advertise have gotten into backend deals with financial influencers, whose main job is to tell the retail investor 24/7 that making money in stock markets is easy and here is how you can do it by trading in futures and options. Which is why social media is full of reels and tips highlighting this easy money.

This has helped drive up volumes and in turn helped stock brokers pay a lower transaction fee to the stock exchanges. Herein lies the twist: the stock brokers make money from this because they don’t pass on this lower transaction fee charged by the exchange totally to the investors. This difference between the transaction fee that the stock brokers charge investors to trade futures and options and what they pay the exchanges is referred to as the rebate. This is how stock brokers make money from the rebate.

As the stock brokerage Zerodha explained in a recent note: “We earn about 10% of our revenue from these rebates. This could range between 10% and 50% of the revenue for other brokers. For us, this has increased from ~3% to ~10% in the last four years because of the increase in options turnover."

Come 2 October all this is likely to change. But before we get to that, let’s try and understand how Sebi is trying to tackle this. The regulator recently issued a circular that has been termed as the true-to-label circular. The circular states: “The charge structure of the market infrastructure institution should be uniform and equal for all its members instead of slab-wise viz. dependent on volume/activity of members."

What does this mean in simple English? It basically means the end of ‘rebate’ as a business model. Stock brokers will no longer be able to pocket the difference between what the exchange charges them as a transaction fee and what they in turn charge their investors. Up until now the transaction fee collected by brokers from investors, usually daily, was higher than the charges they paid to the stock exchange at the end of the month.

This business model will no longer work. The investor will have to be charged the same amount that the stock broker is paying the exchange as a transaction fee. Which essentially means that stock brokers will now have to earn money through avenues other than the rebate. Or as Zerodha put it: “We may have to introduce a brokerage fee for equity delivery investments [that is the buying and selling of stocks], which is currently free, or/and increase futures and options brokerage."

Given the end of rebate, the visible fee, that is the brokerage fee that investors pay to trade futures and options, or stocks, will no longer be zero or very low. The hope is that this will disincentivise the investors to continue punting on futures and options at the pace that they have been.

Now, this is one part of what Sebi is trying to do. There is another important part: that is to rein in the finfluencers. As Madhavi Puri Buch, the Sebi chairperson, recently told Mint: “You open your mouth and utter a single name (of securities), you stop being an educator and start being an advisor."

Basically, the moment a finfluencer recommends a stock or the buying or selling of a future or an option, whose value is derived from the price of a stock, or if they recommend a future or an option whose value is derived from a stock market index, they will be deemed to be advisors and not educators.

And given that, stock brokers or other financial firms regulated by Sebi cannot have any transactions involving money with them. This move is likely to kill the model where stock brokers were quietly funding financial influencers to promote the idea of how easy it is to make money from the stock market.

On the flip side, the line between explaining something and making a recommendation won’t always be very clear, which is why any regulation needs to be drafted carefully.

Before going further, we need to look at two data points. Data from NSE tells us that the mean age of individual investors in the stock market currently stands at 32. It was at 38 in 2019-20. This rapid fall in the mean age of individual investors is a clear indicator of the fact that many of those who have started trading futures and options over the last few years are youngsters.

Further, a bulk of the traders in futures and options are not making very large bets. Data from NSE shows that “more than 3/4th of total investors traded less than ₹10 lakh in equity options in May". Sebi seems to be trying to rein in such investors.

A report in Moneycontrol.com says that a “Working Committee on Futures and Options has recommended increasing the minimum lot size of derivative contracts to ₹20 lakh- ₹30 lakh from ₹5 lakh presently", among other things. Basically, the idea seems to be to make trading in futures and options more expensive.

Now, comes the most important question, will these moves discourage those punting on futures and options: the taxi drivers, the vegetable vendors, the mass of unemployed youth, and many others?

These are good moves, nonetheless, there is one point that they do not tackle. Allow me to explain. The Sebi data from 2021-22 clearly points out that most individual traders lose money when they trade in stock futures and options. This isn’t just an Indian trend. As a March 2023 report inThe Economist pointed out: “Retail investors are losing billions buying stock options."

The point I am trying to reiterate here is that what was true in 2021-22 must have been true in years after that as well: that is, a bulk of retail investors would have lost money while trading futures and options in India.

That leads to the question as to why does trading in futures and options continue to grow then? I mean if someone is losing money, at some point of time they will stop. Common sense will take over. They will run out of money to trade. And so on.

If you speak to those in the business of managing other people’s money (or rather making money from other people’s money) they will tell you India is a big country, more investors will keep coming in. Not the first time the large Indian population has been offered as an explanation for a broad societal trend. While it may true, it’s a very simplistic way of looking at things. There has to be more to this.

Another explanation is that the lottery effect is at play. While investors may be making losses, the hope of having a big pay day keep driving them on. It’s like those who keep losing money in a casino but still keep betting in the hope of winning big. The slot machine will throw up a jackpot someday.Wo subah kabhi to aayegi? Perhaps.

Another explanation offered is that most retail investors are buying options and not writing them, and in a sense, that limits their losses. I haven’t checked out the data on this. This is one explanation that has been offered to me by people who are usually in the know of such things. The retail investors can get up again next morning to start all over again in the hope of a big win. If you have to win in the market, you have to play the market. No one over crossed a sea by standing and admiring it from the shore.

These are societal level explanations and they can all be true to some extent. But I have another explanation to offer. Something known aspreference falsification seems to be at work and that isnudging the retail investors to continue to bet on futures and options despite losing money.

What is preference falsification? As Raghuram G. Rajan and Rohit Lamba write inBreaking the Mould—Reimagining India’s Economic Future: “Political scientist Timur Kuran coined the evocative phrase ‘preference falsification’, which is the act of misrepresenting what one believes, perceiving public pressure to do so. 

For instance, a substantial portion of the population of the Soviet Union was unhappy with the state, but many feared sharing their views openly. It was only when the Soviet state collapsed, weighed down by decades of misgovernance without effective feedback, that people realized others, too, thought the same way."

My hypothesis is that something similar is happening with retail investors trading futures and options, and continuing to trade despite losing money. The environment all around them is extremely bullish. Financial influencers are telling them to go out there and trade. Experts appearing on TV are telling them the stock market will only go up from here. 100,000 in 2025. 160,000 in 2029. And so on.

In this environment, when someone loses money, they are bound to think that they are the exception to the rule. That they are losing money while everyone else around them is making pot loads of it. Also, even those who are losing money aren’t exactly going to admit to it.

This is preference falsification at work because there is very little information on investors losing money by trading futures and options coming out in the public domain. This is perhaps influencing investors to keep trading futures and options even when they are losing money.

Now, how do you tackle a problem like that? In May 2023, Sebi had mandated that stock brokers should display risk disclosures prominently when investors login into their trading account.

These were the risk disclosures:

1) Nine out of 10 individual traders in the equity futures and options segment incurred net losses.

2) On an average, loss makers registered net trading loss close to ₹50,000.

3) Over and above the net trading losses incurred, loss makers expended an additional 28% of net trading losses as transaction costs.

4) Those making net trading profits incurred between 15% and 50% of such profits as transaction cost.

Now, these risk disclosures clearly did not work, because if they had the trading volumes of futures and options wouldn’t have kept going up. It probably became a blind spot like all the gruesome images that appear on cigarette packs warning people of the harmful effects of smoking.

So how can this be tackled? I think Sebi needs to release the data on losses made by individual investors regularly at the end of every month. Just releasing the data will not be enough. Sebi needs to do what the ministry of finance has been doing successfully over the last few years whenever it releases the monthly data on goods and services tax and tries telling the world at large that the Indian economy is doing well: basically, plaster data all over social media.

It needs to learn from what RBI does with its public service ads and what the mutual fund lobby, Association of Mutual Funds in India, has done with its mutual fund sahi hai ads, and get a celebrity to say something along the lines of F&O trading se bach ke rahen (Beware of F&O trading). Short video clips need to be made on how derivatives trading is a loss-making proposition for retail investors. Basically, they need to beat financial influencers at their own game. Or at least try to.

If all this is not enough, then the ministry of finance needs to take out its bazooka and do with futures and options what it did with cryptos: All gains made by those indulging in futures and options for speculation should be taxed at 30%. Further, losses made should not be allowed as a write-off from taxable income.

At the end of the day, one lesson that stands out to anyone who has bothered to read the history of finance and economics is that when financial speculation becomes a mass market activity, it usually doesn’t end well. Which is why it is important to disincentivize it in as many ways as possible. As is the case with one too many things these days, it’s the mahaul (the narrative) that has to be managed.

(Thanks are due to Rahul Goel, a finance and publishing professional, and the former CEO of Equitymaster, for his detailed inputs on this piece).

Also read | Sebi is regulating influencers. What if they’re also mutual fund distributors?