Sebi's New F&O Rules Affecting Retail Investors (Effective November 20, 2024)

22-11-2024

Date Announced: In October 2024, the Securities and Exchange Board of India (Sebi) announced a set of measures to make the equity index derivatives market (commonly called futures & options (F&O)) safer and more stable.

What are Equity Index Derivatives?

Equity index derivatives are financial contracts that are based on the performance of a stock market index, like the S&P 500 or Nifty 50.
These contracts let you bet on whether the index (or overall market) will go up or down in the future, without having to buy the actual stocks.

Types of Equity Index Derivatives:

Futures Contracts:
1. A futures contract is an agreement to buy or sell the index at a specific price on a future date.
2. Example: You might agree to buy the Nifty 50 index in 3 months at today's price, hoping the index will go up by then.
3. If the index rises, you make money. If it falls, you lose money.
Options Contracts:
1. Options give you the right (but not the obligation) to buy or sell the index at a set price before a certain date.
2. There are two types:
  1. Call option: Right to buy the index.
  2. Put option: Right to sell the index.
3. Example: You buy a call option on the S&P 500 if you think the market will rise. If it does, you can buy the index at the lower price and make a profit.

Six Key Measures: Sebi introduced 6 changes, 3 of which will start on November 20, 2024. These changes affect contract size, weekly index derivatives, and tail-risk coverage.
Goal: These new rules are aimed at reducing risky trading, protecting small investors, and making the market more stable.
Expected Outcome: The changes are expected to stop too much speculation, reduce losses for retail investors, and make the market steadier, especially on days when options contracts expire.

3 Important Changes Starting November 20, 2024

(1) Change in Contract Size for Index Derivatives:

New Contract Size: Sebi has set the minimum contract size for index futures to be between Rs 15 lakh and Rs 20 lakh for any new contracts starting November 20, 2024.
Previous Contract Size: Before this, the contract size was between Rs 5 lakh to Rs 10 lakh.
Reason for Change: The idea is to make sure that investors take on the right amount of risk when they trade in the derivatives market. The larger contract size is likely to discourage smaller retail investors from participating.
1. Effect on the Market: Small traders, who make up about 40% of F&O trades, may reduce their involvement because of higher margin (money needed to trade). This could cause a short-term drop in market activity.
2. Long-term Impact: Big institutional investors (who account for about 60% of F&O trading), may take up the space left by smaller traders, leading to less risk-taking and more stability.
3. Expert Opinion: CEO of Whitespace Alpha, believes this rule could help protect small investors from risky, speculative trades that often result in losses.

(2) Limiting Weekly Index Derivatives:

Current Situation: Right now, there are many weekly options contracts available for index derivatives, which leads to excessive speculative trading, especially on expiry days when options prices are lower.
New Rule: From now on, each stock exchange will offer only one weekly index contract for its main index (such as Nifty or Sensex).
Reason for Change: This rule is meant to reduce excessive trading on expiry days, where investors often take big risks on low-cost contracts.
Effect on the Market:
1. Reduced Speculation: By limiting the number of weekly contracts, Sebi wants to slow down the rapid growth of speculative trading, which tends to lose money for small investors.
2. Expert Opinion: CEO of Whitespace Alpha explains that 70% of F&O trading volume is in weekly options, and most of this trading is speculative and loss-making for small traders.
3. Long-term Benefits: The new rule will help bring more stable participation by small investors and reduce volatile, risky trading.

(3) Increase in Tail-Risk Coverage on Expiry Day:

New Rule: Sebi has added an extra Extreme Loss Margin (ELM) of 2% for short-options contracts on the expiry day.
1. What is Tail Risk?: Tail risk refers to the chance of losing a large amount of money due to rare, extreme events in the market. Expiry days often see sharp price changes, which can lead to big losses, especially for traders taking high risks.
Reason for Change: The extra margin is meant to reduce speculative trading on expiry days and make sure traders are prepared for unexpected market movements.
Effect on the Market:
1. Higher Margin Requirement: The 2% margin will make it more expensive for traders to take large risks on expiry days.
2. Reduced Volatility: This change is expected to lower extreme price swings on expiry days, which often lead to large losses for small traders.
3. Expert Opinion: Puneet Sharma points out that retail investor losses on expiry days have sometimes exceeded Rs 1,000 crore, so this change could help reduce huge losses during those times.

Other Measures Coming in 2025:

(1) Upfront Collection of Options Premium:

New Rule: Sebi has said that options buyers must pay the options premium upfront to their trading member (TM) or clearing member (CM).
1. Reason for Change: This will prevent traders from taking on more positions than they can afford, making sure they only trade with the money they have available.
When It Starts: This rule will begin on February 1, 2025.

(2) Intraday Monitoring of Position Limits

Current Issue: There is a risk that traders might create positions that exceed the allowed limits during high-volume trading days (like expiry days).
New Rule: Exchanges will now have to monitor position limits during the day to make sure traders don’t take on more than they’re allowed.
When It Starts: This rule will begin on April 1, 2025.

(3) Removal of Calendar Spread Treatment on Expiry Day

Current Situation: On expiry days, the difference between the futures price and stock price can cause price changes that affect all related contracts, leading to price distortions.
New Rule: Sebi will stop the practice of calendar spread (where traders offset positions across different expiry dates) on expiry days.
- Why?: This will help prevent undesired price movements caused by large-scale trading on expiry days.
When It Starts: This rule will begin on February 1, 2025.

Conclusion:

The new F&O rules by Sebi aim to make the market safer, especially for retail investors, by reducing unnecessary speculation and ensuring more stability. While these changes may make it harder for small traders to participate in high-risk derivatives, they should help protect them from large losses and bring more order and stability to the market in the long run.

What is the difference between Equity Derivatives and Index Derivatives?

Feature	Equity Derivatives (India)	Index Derivatives (India)
Underlying Asset	Based on individual stocks listed on Indian exchanges (e.g., Reliance, HDFC Bank).	Based on market indices like the Nifty 50 or Sensex (e.g., Nifty 50 futures).
Risk Exposure	Risk tied to the performance of a specific stock in the Indian market.	Risk is spread across multiple stocks in the index (e.g., Nifty 50).
Liquidity	Depends on the liquidity of the individual stock. Stocks like Reliance or Infosys tend to be more liquid.	Generally more liquid as index derivatives represent a basket of the top stocks, such as Nifty 50 or Sensex.
Purpose	Used for hedging or speculating on specific stocks' price movements. Traders might bet on stocks like Infosys or TCS.	Used for hedging or speculating on broader market movements. Traders use Nifty or Sensex futures/options to take a view on market direction.
Volatility	Higher volatility, driven by company-specific factors (e.g., earnings reports, news, management changes).	Lower volatility relative to individual stocks, since the index represents a broad market basket, providing diversification.
Settlement	May involve physical delivery of shares (e.g., in stock futures) or cash settlement (e.g., stock options).	Typically cash-settled, based on the closing value of the index (e.g., Nifty 50 futures).
Examples	Stock options/futures on stocks like Reliance, Tata Motors, Infosys.	Index options/futures on Nifty 50, Sensex, Nifty Bank, etc.