The futures and options (F&O) market has registered exponential growth over the last several years. However, what lies behind the beauty of the F&O market is a very dark reality. For the large majority of retail investors, futures and options trading are fraught with risks with potential for significant financial loss.
What Are Futures and Options?
Futures and options are financial derivatives that enable traders to speculate on the future price of any asset, be it stocks, commodities, or currencies. Although complex, the instruments can be used in either hedging (risk reduction) or speculating (betting on price movements).
Futures Contracts: A future is an agreement to buy or sell an asset at a fixed price in some specific date in the future. Each party to the contract has the obligation of carrying it out.
Options Contracts: Options give the owner the obligation but a right to buy or sell a given asset at a given price before a stipulated date. Of the two major types, options exist in call options-that is, the right to buy and put options-that is, the right to sell.
The Dark Reality of F&O Trading
While futures and options trading offer tremendous opportunities for high returns, they come with enormous risks, especially to retail investors who might have little knowledge of the intricacies of these instruments.
1. High Leverage: A Double-Edged Sword
The big advantage F&O trading offers over other derivatives or even cash markets is leverage. That means the trader can manage a big position for a relatively small amount of capital. Amplify profits it does, but so does the loss as much.
2. Speculative nature of F&O Trading
F&O trading is extremely speculative. Value is created overtime in case of long-term investing; in the case of F&O trading, market fluctuations for a very short period drive it. Retail investors usually end up taking the F&O route with the aim of quick gains from very short-period price movements.
3. High Transaction Costs and Hidden Fees
It’s another dimmer reality of F&O trading, wherein the cost of transactions and hidden fees are included. Every trade would incur brokerage fees, taxes, exchange fees, among other charges, in a future and options market. It adds up quickly when the trader has numerous executions in a relatively brief period.
4. Time Decay in Options
It is well understood that time decay-theta-is one of the most critical challenges in trading options. The underlying idea is that an options contract has a life that expires after some period; hence, the closer an option is to its expiration date, the nearer the option is to zero in terms of value. In essence, this implies that even if the underlying asset moves to the desired direction of the trader, the option may actually go down because of the passage of time.
5. Psychological Impact of Trading
The impact of F&O trading is extremely psychological on the minds of the traders, especially the retail ones. The pressure on making quick decisions triggers additional stress and anxiety because the price movements have to be constantly observed. Traders find themselves getting fear of missing out or panicking when they hold their positions against the moving markets. At such times, they are left making haphazard trades and poor decisions.
6. Without Knowledge and Expertise
It involves too much complexity and is not suitable for new investors. Most retail traders, however, enter the F&O market without knowing fully well what they trade. Most of them do not know the term ‘strike price’, ‘premium’, ‘margin’, or ‘hedging’, yet they enter trades without proper information.
7. Loss More Than Invested
In the futures market, the holder needs to put a margin with the broker for holding a position. Then, in case of a move against the holder, they receive a margin call, forcing them to deposit more funds in order to cover the loss. In this way, their position can be liquidated, and they may lose more than initially invested.
Regulatory Concerns
SEBI has raised concerns with regard to the growing participation of retail investors in the F&O segment of the Indian stock market. Because of these risks, it has taken several regulatory measures to safeguard traders from such imbalanced and unhealthy practices.
SEBI was forced to raise margin requirements to restrict excessive leverage used by the retail investors in trading and usher in position limits to check over-size positions on the part of retail investors.
Requiring brokers to provide full risk disclosures to futures/-options traders.
Conclusion:
The high leverage coupled with the speculative nature of such instruments, along with complexity, means there is great potential for large financial losses when an investor does not understand what is happening in the marketplace.
That is, essentially, for those who are thinking of entering the F&O market, education, small positions, and avoiding excessive leverage will become crucial. Most importantly, retail investors need to realize that whatever might have tempted them to come into F&O trading should not end in the tragic dark realities.
