Option trading mania has reduced big payoff chances on expiry day: Squareoffbots founder

You don't need a phenomenal bull market to make significant profits, says Kirubakaran Rajendran.

Kirubakaran Rajendran first got interested in trading after watching a chauffeur pick up a business newspaper for his boss every day from the newspaper stand opposite the bus stop where Rajendran was waiting for his ride to college. After dabbling in stocks based on the information that appeared in the media, and a brief stint at an IT firm, Rajendran became a full-time stocks and derivatives trader from 2014. In an interview to Moneycontrol, the founder of squareoffbots.com, a platform that offers automated trading bots, said that daily expiries in options contracts have reduced the volatility in a particular index on that day, and made it much tougher for traders to generate profits. Among other things, he spoke about the trends that have led to the explosive growth in options trading post-pandemic.

Edited excerpts from the interview:

Q: The futures and options (F&O) market has seen explosive growth in volumes as well as the number of traders. Previously, people would start with fundamental investing and then move on to F&O. Now you have a situation where many are directly starting off with F&O. What are the factors you think have driven this trend?

A: Content certainly has been a big driver. Back in 2016 or 2017, if you were looking for trading-related content on the web, you wouldn't have found much. But over the last 3-4 years, there's an abundance. In the past, you would find most trading information in Hindi, and some in English. But today, you can find it in multiple regional languages like Telugu, Malayalam, and Tamil. What's more, these videos are getting millions of views. This surge in content has drawn a lot of youngsters to the market. What's interesting is that most of these content creators don't focus on traditional approaches like the Warren Buffett style of investment, where you analyse a company's fundamentals. Instead, they talk about options trading, trading strategies, and various technical indicators—it is all about very short-term trading. So, people who watch these videos get attracted to intraday activities, options trading, or futures trading over time.

Also read: Technical View | Nifty gains momentum, experts say next hurdle at 19,600

Q: SEBI’s study has shown that over 90 percent of F&O traders lose money. And yet the mad rush for options trading continues. What explains that?

A: Multiple things here. Previously, you needed a one-sided bull market to make a lot of money. We saw that during 2006-08. The key difference now is that you don't need a phenomenal bull market to make significant profits. A skilled derivatives trader can make consistent profits even in a sideways market by trading in options. Another notable change is the frequency of market events. Previously, there used to be an expiry on the last Thursday of every month. Now we have an expiry across NSE and BSE options contracts on every day of the week. On these days, there is at times a huge swing in premiums which allows some traders to make two to three times their capital in a single session. The majority of the new traders tend to have recency bias, and will focus on recent events rather than analysing long-term historical data. Having gotten lucky once, they think it can be repeated, and then start engaging in high-risk strategies.

Q: What has been the result of having an options expiry on every single day of the week? Has it made the market more volatile?

A: In fact, most traders are finding it harder to make big profits because the volatility in a particular index on expiry day has reduced significantly. When trading in options, you typically short (sell) specific strike prices for both call and put options. For instance, if the Nifty is currently trading at 19,000, an option seller might choose to sell a 19,500 call option and a 19,000 put option. This strategy assumes that the Nifty will largely stay within this price range. Since option sellers have deeper pockets, compared to option buyers, and also are more sophisticated, their decisions are mostly right. When more option sellers start using this strategy of shorting specific legs of a particular index, the gap will narrow, and prices will move closer to the spot levels. As a result, the option sellers want the index to trade within that narrow range so that they can make money. Due to this, the expected movement on the index itself has gone down significantly on expiry day.

Q: Is it going to be this way forever?

A: No, this is not permanent. When something is widely discussed, say war, rate hike, inflation, these factors will reflect in the price. Risk is what the market cannot see. If there is some bad news like COVID in 2020, you will see volatility surge. Till such time, you may not see any big volatility.

Q: What has been traders’ response to the weekly options contracts introduced by the BSE?

A: However hard the BSE tries, it will not yield immediate results because it takes time for the market to warm up to a product. For instance, the introduction of Bank Nifty weekly options in May or June 2016 initially saw limited interest. It wasn't until 2017 that it began gaining momentum. Similarly, Nifty weekly options, which came into play in 2019, took some time to become popular. When FinNifty was introduced, it took roughly nine to eleven months for it to become the segment with the highest turnover on Tuesdays. My guess is that Sensex options too will have to go through a similar journey. Also, more brokers need to enable BSE’s derivative products on their terminals. That has not happened in a big way so far. But BSE has one advantage. The pool of F&O traders in the country today is much bigger than what it was some years ago. Once BSE’s products start gaining acceptance, it can take off in a big way.

Also read: Only online mode to credit money to the investor protection and education fund: Sebi

Q: There are concerns of systemic risk because of the huge volumes in the F&O segment. What do you think?

A: The situation is much better than what it was back in 2008 when you had retail investors taking huge positions in the futures segments and brokers not collecting adequate margins. Today, brokers don’t allow their clients to take up that kind of positions because the margin rules are stringent. It is highly possible that a large number of traders can get wiped out if there is a sharp move at some point. That is because many of them are pursuing high-risk strategies without fully understanding the implications. For instance, imagine you have a trading strategy, and according to historical data, it indicates that the maximum drawdown is typically around 10 percent. In a single trade, you might only incur a loss of 1 percent or 2 percent. This is what your trading system, based on historical analysis, suggests. If it happens to be on a contract like FinNifty, you have barely two years of data. During these two years, there hasn't been a wild move in FinNifty. But the major problem I'm seeing now is many traders are new to systems trading, so they just blindly believe what has happened in the past is going to happen in the future. They need to consider the worst-case scenario when developing a trading system and accordingly design their money management rules. Still, the possibility of brokers getting wiped out in large numbers looks less likely unless there is some extreme event in the market. Say, for instance, something that happened in the US when the stock exchanges were shut for some days after the 9/11 attack, or trading being suspended for a few hours because of a technical glitch. But you can never collect enough margins for those kinds of events.

Q: What are the majority of the new traders doing—are they buying options or selling them?

A: Depends on the kind of capital available to the trader, his socioeconomic background and what the objective is. People who come from tier 2 and 3 cities usually have limited capital but high expectations. These are usually option buyers, which is a high-risk, high-return strategy. Traders from tier 1 cities are mostly from the IT industry. They are looking for a stable source of second income, which is possible through options selling. Also, many traders graduate from being option buyers to option sellers after having been around for a couple of years. They would have tried out a few things before realising that there has to be a better way of earning consistent profit even if small, and go in for option selling with hedges built in. In my experience, those who have built a certain amount of capital would then not want to risk it all, and then go in for strategies that limit losses whereas those with limited capital are the ones willing to take more risk.

Q: There is this debate that the rapid growth in derivatives in the country is killing the culture of investment, which is a far more productive one for the development of financial markets as well as the economy. Your thoughts.

A: Investing and trading are distinct activities. I don’t think just because more people are trading in derivatives, that will lead to fewer people going in for long-term investing. In developed countries like the US, where trading activity is already much higher, companies like Amazon and Microsoft have still managed to generate substantial wealth. Investing primarily relies on the underlying performance of a business. Therefore, an increase in trading activity, even with more participants, won't fundamentally alter a company’s ability to create wealth for shareholders if the business fundamentals are sound. But yes, it can lead to increased volatility, with prices swinging sharply in the short term.

Q: What is your advice for aspiring traders?

A: Have a back-up source of income for the period that you are trying to establish yourself as a trader. That could be a job or it could be some business on the side. It need not be a large amount but it should be enough to take care of your living expenses so that you are not under pressure all the time to generate profits. If you are dependent solely on your trading income to buy your provisions and pay the rent, then you will be under so much pressure that you will end up making mistakes and eventually quit trading altogether.

Q: How did you manage in the initial days of your trading career?

A: I had saved a decent sum when I was working with an IT company. In addition, I was writing code for automated trading systems and selling them. That helped me stay afloat till the time I found my feet as a trader