On the morning of April 13, clients of discount broking platform Shoonya panicked after realising they were unable to put through trades. Reason: a technical error in the broker’s system. To complicate matters further, many traders using the Shoonya app saw their accounts showing trades they had not done.
Thursday being the expiry for weekly contracts in Bank Nifty and Nifty, these traders did not want to take a chance. Unable to square off the positions on Shoonya, they took offsetting positions through other brokers to minimise potential losses. Traders who managed to square off the ghost trades on Shoonya found the reversal trade showing as a new transaction in their accounts at the end of the day.
Many are staring at a loss of anywhere between a few thousands and a few lakhs of rupees. Others saw their profits shrink because of the reversal trades. There were a few lucky ones like Jaipur-based Harsh Khandelwal who ended up with a small profit on positions he took on other platforms to offset the erroneous trades.
“Things were looking bad during the incident, but (the) final outcome turned out to be positive in my case,” he told Moneycontrol, adding that a few of his friends made bigger profits on similar trades.
Shoonya put out a statement asking its clients to check contract notes for any discrepant trades and close the open positions before 9:30am on April 17. After that, clients have to submit their case to Shoonya’s risk assessment team “for a review and an amicable resolution”.
On the face of it, this may appear to be yet another dispute between a broker and its clients. This is not the first instance of traders losing money because of the broker’s system faltering, neither will it be the last. But the episode needs to be viewed in light of the increasing concern among regulators worldwide due to the explosive growth in equity options trading over the last couple of years, particularly by novice retail investors. It is not just in India that options trading has taken off in a big way; the US market too is witnessing a similar trend.
Hedging tool turned lottery ticket
Originally intended as an instrument to hedge risks, options are now being treated as a lottery ticket by rookie traders who took to stock trading after the pandemic. A combination of factors has led to this situation.
One, the payoff: you stand to make big money for a small initial investment if you buy options and the price moves in your favour. That is not the case with stocks or even futures for that matter, where the initial investment is much higher.
Two, as Sebi kept tightening the margin money to be deposited upfront with brokers, retail investors increasingly shifted to options trading, where margin obligations can be managed through offsetting positions for a small cost.
Three, a near one-sided rise in the market between March 2020 and October 2021 resulted in many traders making huge profits through basic strategies like buying call options (betting on the market to rise) and selling put options (betting market won’t fall).
Explosive growth
Between FY20 and FY23, average daily turnover value in index options has grown 10-fold to around Rs 45,000 crore and that in stock options has grown nearly fivefold to around Rs 3800 crore. During the same period, average daily turnover in stock and index futures has not even grown by 50 percent.
Cash market growth has been equally dismal. With the result that the gap between cash market turnover and equity derivatives turnover has widened to an extent that it is now a case of the tail wagging the dog. Interestingly, the craze for derivatives trading is despite it being widely acknowledged that most traders lose money.
A recent Sebi study found that nine of out 10 derivatives traders lost money, and even among those who made gained, only a handful made meaningful profits.
Why?
“Recency bias is a major factor that keeps most amateur traders at the game,” Chennai-based F&O trader Kirubakaran Rajendran told Moneycontrol. “If you make money once, you will keep trying your luck repeatedly even if you lose many times. The smarter ones will learn and keep refining their strategies, but for the majority, there is little difference between trading and gambling.”
This is the trend globally too. According to a paper in the Journal of Finance, between November 2019 and June 2021, retail investors in the US collectively lost $2.1 billion trading in options.
Subsidising low brokerage
The BSE and NSE offer incentives to their trading members and market makers who help drive derivatives market turnover. This is in the form of rebates and cash payouts. The practice is no different from that seen in other industries where distributors, dealers etc generating big volumes are rewarded by the companies whose products they sell. Options traders have to pay an exchange transaction charge of Rs 53 per Rs 1 lakh of premium turnover.
This is a fee that brokers have to pass on to the exchange. But if the broker generates over Rs 2000 crore of options turnover a month, the transaction charge works out to Rs 33 per lakh.
Most brokers charge their clients the highest rate of Rs 53 per Rs 1 lakh and then collect Rs 20 back from the exchange. This helps the brokers offer rock bottom or even zero broking charges. Rs 20 on Rs 2000 crore works out to a rebate of Rs 40 lakh. Average daily options turnover in FY23 was Rs 48,000 crore. A broker with 4-5 percent market share can earn Rs 40 lakh in rebate on a daily basis. A major attraction of Shoonya for traders was that it did not charge any brokerage, clearing and account set up and demat fees.
The flipside
The are two major concerns raised by market experts against the uncontrolled rise in options is that one, it distorts market reality and amplifies volatility. Concentrated bets increase systemic risk. A lot of option sellers trade on the assumption that the market will stay within a certain range. If the market moves sharply on either side of the widely expected range, option sellers will be forced to take bets in the same direction to minimise their losses.
For instance, a trader who sold a put option will have to sell stocks/futures in case the market breaks on the downside. Likewise the seller of a call option will be forced to buy stocks/futures if there is a break out on the upside. In theory, options traders are supposed to be using hedging strategies that minimise risks in the event of an adverse price move. But the reality is different. There is a cost to hedging and too much hedging also limits potential profits.
In addition, the widespread use of algorithmic trading strategies can exacerbate the move as high frequency traders move in to make a quick profit. And the outcome can be disastrous even for the smartest of players.
Volmaggedon and LJM
In February, a sudden spike in the CBOE Volatility Index surged from 17 to 50 in just four trading sessions, causing massive losses to players who had sold options on volatility betting that it would stay low. This spike in volatility was triggered by a number of factors, including concerns about inflation and interest rates, geopolitical tensions, and algorithmic trading strategies that exacerbated market movements.
As a result, investment funds managed by Chicago-based hedge fund LJM Partners suffered trading losses of more than $1 billion, and shut down its flagship fund, the LJM Preservation and Growth Fund, and returned what was left of the capital to investors.
Other risks
On February 24, 2021, trading on the NSE was suspended for more than three hours following a technical glitch. It was only at 3:27pm that the NSE told its members that trading would resume at 3:45pm. By then, many brokers had squared off open positions of clients, not wanting to take a risk on where the market would reopen.
And their fears may not have been misplaced. When the market reopened, Nifty February futures briefly traded at a premium of over 500 points to the spot index, a rare occurrence.
"Most traders prefer to use a stop loss rather a hedge (an opposite derivative strategy) to minimise their loss,” says Rajendran. “This is a risky approach because in a highly volatile market, the prices can go way beyond your stop loss. Also, stop loss does not factor for extreme market moves, where trading itself can be halted for a while. If market opens gap down or gap up when trading resumes, the stop losses won’t be of much help."
Commodity brokerage firms in India are estimated to have lost over Rs 300 crore in April 2020 when crude futures prices turned negative. Many traders lost multiples of the margin money they had in their trading accounts because of the unprecedented price collapse in the crude futures market, and it fell on the broking firms to recover the balance.
Zero day to expiry options
A similar situation is playing out in the US as well, where there is frenzied activity in zero days-to-expiry (0DTE) options, which as the name suggests, expire on the same day. According to Bloomberg, roughly 40 percent of the S&P 500’s trading volume is now accounted for 0DTE.
Besides the systemic risk, the unusually massive interest in 0DTE also threatens to blunt the effectiveness of the CBOE Volatility Index (VIX) as a sentiment indicator. That is because VIX measures the market's expected volatility over the next 30 days based on the prices of S&P 500 index options.
If the prices of 0DTE options start to dominate the VIX calculation, it could give a distorted picture of the market's expected volatility over the longer term. According to a report by the Financial Times, US derivatives regulator Commodity Futures Trading Commission is examining potential risks or systemic issues that could arise from the zero-day trading strategies, after analysts cautioned about its ill-effects.
India’s 0DTE version
The Indian market does not have 0DTE options, but there are signs that many traders are taking a 0DTE-like approach to weekly options going by the abnormal spike in volumes on expiry day. That is prompting bourses to keep the expiry day of weekly options contracts in a way so that they get the maximum attention from traders.
For instance, NSE’s Fin Nifty options expiry was shifted to Tuesday from Thursday a few months back. That has resulted in Fin Nifty being the most actively traded option contract on Tuesday, ahead of even the Bank Nifty and Nifty. NSE’s Midcap 50 option contracts have a Wednesday expiry. The BSE has changed the expiry day for its weekly Sensex contracts to Friday from Thursday, effective from May 15.
History repeats?
During the bull run of 2007-08, single stock futures trading was the rage among retail traders. Companies sought the help of market operators to inflate their stock price to make the cut for the NSE’s F&O list. Many midcap companies’ promoters would celebrate the inclusion in the list with a lavish party. When the market peaked in January 2008, a rapid unwinding of the futures positions compounded the panic, sending indices crashing over 20 percent in a week.
The Sebi and the exchanges then took steps to prevent of the repeat of the situation. The NSE reviewed the F&O list and many companies were excluded. The markets regulator raised the value for the minimum lot size of contracts to Rs 2 lakh to restrict entry of retail traders. For a while, sanity returned to the derivatives market. With futures having become expensive to trade in, gradually the focus shifted to options. Still, the growth in options turnover was steady till the pandemic struck.
The frenzy in options trading that began since March 2020 has showed no signs of abating even though trading volumes in the cash market has come off sharply from the peaks of FY22. For those who have seen the bull run of 2007-08, the hyper activity in the options market is eerily reminiscent of the mania in single stock futures. The only difference is that the options market appears to functioning like a parallel universe with little connection to goings on in the cash market.
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