A large number of retail traders dabble in futures & options (F&Os), drawn by high leverage and hopes of high returns
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(Photo: Reuters)
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The regulatory action against Jane Street has brought renewed attention to the equity derivatives market. It may be premature to comment on the Jane Street affair since there is a fine line between manipulation as alleged, and price arbitrage as Jane Street claims. However, it is clear that there are imbalances between the cash and derivatives segments of the equities market, which is what hedge funds and sophisticated traders look to exploit. As a senior official of the Securities and Exchange Board of India (Sebi) recently pointed out, the nominal turnover of the derivatives market was 350 times that of the cash market and this was not a normal situation. While India’s market capitalisation makes it the fifth-largest stock market by size, its derivatives market is the world’s largest by volume.
A large number of retail traders dabble in futures & options (F&Os), drawn by high leverage and hopes of high returns. However, many studies by Sebi have indicated that over 90 per cent of retail traders lose money in the F&O segment. Their collective losses totalled over ₹1 trillion in 2024-25. Derivatives are a zero-sum game. So, some traders are gaining by the amount equivalent to what others have lost, less the exchange fees and taxes. It is true that the money might be more gainfully deployed in targeting long-term capital appreciation via investment in more productive assets like shares, rather than being speculated away in wasting assets like options, which expire on a given date. Not without reason has the regulator given many warnings to retail traders detailing the risks of derivatives trading, and it reportedly intends to roll out an even more comprehensive awareness campaign. It may also be looking at measures to curb trading in instruments on expiry day. This is especially popular with retail traders. Options are very cheap just hours before they are due to be extinguished. Hence, there is more bang for the buck for leveraged traders and small price swings can result in huge gains or losses.
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However, there are several things the regulator should consider before announcing new measures. It took steps in November last year to curb speculation in derivatives and those have had an impact since the volumes are now lower. More curbs, and the impact of reported scrutiny of the operations of hedge funds, may lead to a further decline in volumes. This would make it hard for the F&O market to fulfil useful purposes like ironing out price imperfections through its mechanisms of arbitrage, offering cost-effective hedging possibilities, and creating depth for the equity market. In this context, the old maxim of “caveat emptor”, or “buyer beware”, comes into play. Those who have lost money know they have lost money and every derivatives-trading platform now flashes warnings about the dangers. If retail traders choose to take risks anyway, it may not be prudent for the regulator to stop them so long as market stability is unaffected. What the regulator may continue to do is to spread awareness through sustained educational campaigns.
Besides, it has been argued that one of the reasons for the imbalanced volume ratios is lack of leverage in cash equity and lack of activity in the secondary bond market. Hence, it is correct that there are abnormally high volumes in derivatives. However, if market mechanisms and regulations focus on improving the cash market turnover in both the debt and equity markets, the imbalances may start to correct.
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