Options trading is a way of dealing with contracts that give the buyer the right (but not the obligation) to buy (call option) or sell (put option) a certain asset (such as a stock) at a certain price by a certain point in time. This is a bet on the future price movement of an asset.
Market regulator SEBI is looking at ways to ensure options trading is conducted responsibly and protect investors from excessive risk.
SEBI is concerned about the recent surge in options trading, particularly by retail investors, for several reasons:
- Higher Risk: Options trading can be much riskier than standard stock purchases. Options contracts have a time limit, and if the price does not move in your favor by the expiration date, you lose your entire investment. This can be particularly risky for new investors who do not fully understand the risks involved.
- Potential for Market Manipulation: Trading large amounts of options on a particular stock can create artificial price movements and volatility, potentially harming overall market stability.
Why Trade Options on Radar? What are the latest updates?
SEBI is considering a series of adjustments to its derivatives trading rules to address risks arising from the explosive growth of options trading, according to a recent report by Reuters.
The report added that the new rules could include higher margins and more detailed disclosures for options contracts and are being considered following a series of meetings with exchanges, brokers and fund houses over the past four months.
Trading of indices and stock options in India has surged over the past few years, mainly by retail investors, sparking warnings from market participants and government officials.
The notional value of index options in 2023-24 more than doubled from the previous year to $907.9 trillion.
An out-of-control explosion in retail trading in futures and options could spell future trouble not only for markets, but also for investor sentiment and household finances, India's federal finance minister warned last month.
One regulatory source told Reuters that adequate risk disclosure and measures were needed to prevent excessive speculation or possible manipulation.
The first step regulators are considering is linking options trading with underlying cash volumes in stocks to curb the accumulation of open positions in less liquid stocks, the people said.
Margin requirements for trading options will increase if option positions become overly accumulated relative to cash volume, they said.
Options trading volume in India is approximately four times the underlying cash volume, while the global average is between five and 15 times.
“These rates have caused concern,” a second source said.
The U.S. derivatives-to-cash ratio is about 9x.
SEBI will also propose to increase disclosure of index and stock option contracts rather than limiting it to only options activity and open interest as is currently the case, the sources said.
The regulator plans to ask exchanges to charge brokers a flat fee regardless of the transaction amount, the sources said.
Earlier this month, SEBI proposed stricter rules for individual equity derivatives, which, if implemented, would exclude derivatives involving illiquid stocks.
The proposed changes are at discussion stage and will undergo public consultation over the coming months before being introduced, the sources said.
Any guesses that come to mind?
Of the 108 billion options contracts traded globally in 2023, 78% were on Indian exchanges, according to data from the Futures Industry Association (FIA). Individual investors account for 35% of domestic derivatives trading.
In April, 78% of trades on the National Stock Exchange, India's largest exchange, were made by investors trading less than 1 million rupees ($11,969).
The surge in trading volume created opportunities for foreign trading companies.
US-based Jane Street and Millennium are currently locked in a legal battle in court, with the former suing the latter over its Indian options strategy. Jane Street claimed that the strategy generated approximately $1 billion in revenue in 2023.
No zero-day expiration options contract has been launched by any Indian exchange yet. Zero-day expiration options contracts are a popular strategy of purchasing option contracts on the date they are scheduled to expire, helping traders mimic similar contracts available in markets such as the United States.
A source familiar with government thinking said that in private conversations, officials expressed reservations about the surge in zero-day options trading.
This is pure speculation and serves no purpose in the market, the sources said.
The government has also asked regulators to consider whether the lot size of options contracts could be increased to prevent very small investors from entering the market, the official said.
An email was sent to India's finance ministry last Friday seeking comment, but no response has yet been received.
Will Acworth, FIA senior vice president of data and research, said options volume growth in India is explosive and much higher than anywhere else in the world.
“The real problem for the government and SEBI is more about investor protection than the risks to the financial system,” Acworth said. He added that buying options without fully understanding the product is similar to gambling.