Equity Derivatives: Not for the Uninitiated

Equity Derivatives: Not for the Uninitiated

Sub: Economy

Overview

Equity derivatives, such as futures and options, are financial instruments used primarily for hedging purposes.

However, for individual investors, these instruments often lead to substantial losses due to a lack of expertise and awareness.

SEBI’s Warning

In May 2023, the Securities and Exchange Board of India (SEBI) issued a circular highlighting the risks associated with equity derivatives trading for individual investors:

• Losses: 90% of individual traders in equity derivatives incurred net losses.
• Average Loss: Loss makers registered an average net trading loss of ₹50,000.
• Transaction Costs: Loss makers spent an additional 28% of their net trading losses on transaction costs, while those making profits spent between 15-50% of their profits on transaction costs.
• Risk Disclosure: SEBI mandated that traders be prominently shown risk disclosures upon logging into their trading accounts.

Despite these warnings, individual participation in equity derivatives remains high.

Trading Volume and Participation

• Increased Activity: Between May 2023 and April 2024, the average daily turnover (ADT) in equity derivatives rose from ₹1.62 lakh crore to ₹2.54 lakh crore.
• Individual Investors: The share of individual investors in the equity derivatives turnover slightly decreased from 26.8% to 25.5%, but the higher traded volume indicates increased participation. The number of individual investors in NSE Futures & Options surged from 10 lakh in 2018-19 to about 96 lakh in 2023-24.

Issues with Individual Participation

• Lack of Awareness: Many individual traders lack the necessary knowledge and experience compared to professional traders and proprietary books, which dominate the market.
• Speculation vs. Investment: Trading in derivatives is speculative and not aligned with long-term wealth creation. Most individuals should focus on long-term investments like stocks and mutual funds.
• Influencer Courses: Unregulated short courses by influencers claiming to make participants experts in derivatives trading are misleading. These courses are neither approved by SEBI nor run by licensed professionals.

Fundamental Aspect of Equity Derivatives

• Purpose: The primary purpose of the equity derivatives market is hedging, not speculative trading. Investors should use derivatives to hedge their portfolios, not as standalone investment tools.
• Risk Management: Trading in derivatives without proper knowledge increases risk exposure. Individuals should keep derivative exposure limited and learn through experience over time.

Conclusion

Equity derivatives are complex and require significant expertise. Individual investors should:

• Limit Exposure: Keep derivative trades to a small portion of the portfolio.
• Focus on Long-Term Investment: Prioritize long-term investments in stocks and managed portfolios.
• Gain Experience Gradually: Understand that expertise in derivatives trading comes with years of experience, not short-term courses.

By approaching equity derivatives cautiously and prioritizing long-term investment strategies, individual investors can avoid substantial losses and build wealth more effectively.