The recently released SEBI (Securities and Exchange Board of India) report on losses suffered by individuals in equity derivatives trading (futures and options — F&O) prompts me to narrate a story.
Two friends, Bob and Sievers, plan to go seal hunting to Alaska and bring back a couple of their conquests. They negotiate with the owner-pilot of a helicopter for the trip. The chopper has the capacity to bring only one seal. They go to the designated place and hunt two and cajole the pilot to carry the extra load. On the way, the engine develops a snag with the burden of a heavier weight. The pilot says that there's no other way but to land immediately. He somehow manages to avoid a crash with the mountains and descends in a valley full of trees. However, the chopper is not fit for flying again.
Bob and Sievers look at each other despondently. The pilot looks at them helplessly and accusingly. Sievers is the first to open his mouth. “Bob, doesn’t this place seem familiar?” Bob responds with a blank look. “Yes, looks like the same place we crash-landed in last year.”
Outcome of derivative trading
From a macro perspective, equity derivatives per se are not a loss-making proposition. The writer of the option pockets the premium. Unless the market movement is adverse and the option buyer exercises the put / call option, the option writer ends up making money. Your trading outcome depends on how you are participating in the market, and of course the price movement. What has happened is a transfer of money. Loss for some, gain for some.
In 2023-24 (FY24), proprietary traders (a trading member of the Exchange, trading on his own account) earned a profit of Rs 33,037 crore and FPIs (foreign portfolio investors) earned Rs 27,965 crore. Individual traders (akin to Bob and Sievers in the story above) incurred losses of Rs 41,544 crore (NSE before expenses). About 91.1 percent of individual traders (approximately 73 lakh) lost money in the F&O segment in FY24, about Rs 1.20 lakh on average.
During FY22-FY24, 1.13 crore unique individual traders incurred a combined net loss of Rs 1.81 lakh crore in F&O. In FY24 alone, individuals lost about Rs 75K crore net (NSE and BSE after brokerage and expenses). More than 1 crore loss-making traders (92.8 percent of individual traders) lost, on average, about Rs 2 lakh per person in F&O trading in the three year period. Only 1 percent of individual traders managed to earn profits exceeding Rs 1 lakh, after adjusting for transaction costs.
How did it happen?
The smart boys, the proprietary traders and FPIs, do it through algo trades. About 97 percent of the profits of FPIs and 96 percent of the profits of proprietary traders came from algos in FY24. Almost half the F&O traders that year (42 lakh) were new, i.e., they were trading for the first time in this segment. More than 75 percent of the loss-makers persisted with trading in the segment, despite making losses in the preceding two consecutive years.
To use an analogy, there is a chess algo built into a supercomputer. It is one thing if a grandmaster is going up against it. But if you have just learned chess and are taking it on, that's entirely different.
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Behavioural biases
Why do people make losses in derivatives and futures & options? For these simple reasons:
Overconfidence bias
Too many people overvalue what they are not and undervalue what they are. Overconfidence can be summarised as unwarranted faith in one’s intuitive reasoning, judgement, and cognitive abilities.
Certainty overconfidence
People display certainty overconfidence in everyday situations, and that carries over into the investment arena.
Optimism bias
You have heard of rose-tinted glasses and know that those who wear them tend to view the world with undue optimism. Empirical studies show that with respect to almost any personal trait perceived as positive — looks, sense of humour, physique, and so on —most people tend to rate themselves above the population mean. Investors tend to be optimistic about the potential for positive performance of the investments they make.
Conclusion
Equity F&O can be used for three purposes: (a) hedging your cash (spot / long) positions; (b) speculation; and (c) arbitrage. If you are just learning the ropes of speculation, the data is in front of you.
Disclaimer: The views and investment tips expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.
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