Harms of retail derivatives trading should give regulators pause and set in motion a meaningful regulation of the activity
Retail investors, who trade stock market derivatives in India, may have several signs similar to problem gamblers. In addition, a high level of trading in derivatives is also hypothesized to produce risks for the financial markets if engaged in irrationally.
This suspected irrationality comes from the property of derivatives where they have high leverage, and thus act similar to a lottery ticket: the cost of the ticket is written off if the outcome being bet on doesn't occur, but a high payout accrues if the outcome does occur - or even if its probability is perceived as increasing by other buyers.
Each day of the week now has a derivative expiring the same day, and the derivative's price swings become a very visible and viral trend inviting retail investors to participate. Shifts in India's work habits may also have aided, since several jobs permit unsupervised breaks and pandemic-era work-from-home (WFH) continues. This gives many retail traders the time and autonomy to study derivatives opportunities followed by booking and tracking a particular derivative, setting up risks that could be avoided.
Derivatives Domination Of India's Stock Market
In the case of India, there are concrete suspicions about retail investor dabbling in derivatives. A newspaper report from Oct 2023 describes how a particular derivative has become like a quick-outcome lottery ticket: purchasing a relatively low-priced Rs 2,000 option allows an exposure to Rs 10 lakh of securities.
This price happens to be relatively low due to the lower volatility premium required by parties who sell these options, since time to expiry is low. Such options are also largely speculative bets: in the US, a retail investor holds such a '0-days to expiry' (0DTE) option for just tens of minutes.
The weekly index option on the NSE Nifty index makes for 95 per cent of all traded instruments indicating a very high volume. In the US 0DTE trading crossed the 50 per cent mark of total trading activity around 2022, and haven't risen beyond that fraction, yet the same concerns as India have been reported. A securities expert even cautions that "investing" is not the appropriate term to use for the frenzied trading in 0DTEs. In both countries, the expiry of different types of derivatives contracts have been spread over the five working days. Investors now have different low-priced derivatives to trade in each day - all within their most active phase of volatility and enjoying high liquidity.
In another report of the situation in India, it is described how the derivatives phenomenon has been supercharged by social media savvy 'finfluencers'. Besides these, there are also intrinsic motivations such as the need to cover monetarily for pandemic-era job losses, lack of business at the investors' own establishments or reduced bonuses from employers. This report highlights how the odds in fantasy sports betting are better than those of a profit from derivatives trading.
This suggests another latent cause: the losses from derivatives are perceived as less embarrassing than similar activity in fantasy leagues or horse races. This is the social context in several emerging economies. An academic investigation in Thailand concluded that stock market gambling owes to conventional methods of gambling such as horse racing, casinos or slot machines being considered taboo in several social strata. Reports about India's derivatives mince no words and advocate for a clear declaration that Futures and Options trading - both derivatives - is addictive.
The age profile of derivatives traders should cause concern in India as digital convenience enables over-50s to adopt the practice. In the US, over-50s were the fastest growing segment of problem gamblers - making 50 percent of that group even in 2014. We may infer that over-50s in India will also find this gamification of derivatives to be as attractive as physical and public means of gambling like casinos.
It is important to seek some concrete evidence of dependency. In South Korea, during the COVID19-enforced WFH, a problem dependency arose among day-traders which prompted three times as many sessions by traders with dependency counselors. The financial product that these day-traders indulged in were stocks and not derivatives, though the Korean stock exchange also has extended trading for several hours now to accommodate currency derivatives. A previous speculative boom in cryptocurrency was pointed to as the origin of day traders' sensation-seeking.
Interestingly, eyeing the trading revenues that would accrue to it, NSE rolled out a financial product similar to weekly index options in the attractive day trading market that South Korea had become. A 2018 study based on traders in China established that there are behavioural impulses driving trading.
With a newer methodology to match a trader's stated and revealed preferences, it was seen that traders had a high level of gambling preference (sensation-seeking) and also reported a perceived information advantage (overconfidence). Derivatives were not popular at the retail level in any stock market at the time, but we can extend this to our situation due to how similar the derivatives trade is to a lottery ticket or a gambling experience.
Need For A Watchful Eye
A counter-argument is that all forms of trading improve the liquidity in market, and this has indeed been established even in the compulsive day trading of 'lottery stocks'. But does this silver lining apply, without caveats, to the type of intensive derivatives trading that we see now?
For many months in 2023, US commentators wrote with concern about the high level of activity in 0DTE, with the risk being higher on days where the stock market had sudden moves due to geopolitical or natural disaster news. The hypothesis goes that a high volume of positions in derivatives will cause a problem similar to short covering - a possibility dubbed 'Volmageddon'.
A US stock exchange has evidence in at least one episode to deny this hypothesis, but financial institutions might still consider this possibility as intuitive and likely, thus bulking up the costs of genuine investment activity via layers of hedging or insurance. In India, RBI's 'Financial Stability Report' of Dec 2023 opined that collateral-free lending from RBI's regulated entities - banks and NBFCs - was being used to obtain leverage on stock market movements through derivatives. The RBI is not the stock market regulator in India, but the issue is serious enough to warrant attention from a system stability perspective. This report even identified a co-relation between active periods in the derivatives market and phases of heightened uncollateralised lending.
Similarly, curbs on derivatives may be mistaken as impinging on freedom of activity or enterprise of a country's citizens. Yet, an approach that gauges the health and ethics sustainability of this activity would be appropriate here. Day traders' emergent form of dependency was clinically examined in work belonging to the field of psychiatry in 2016. Almost all patients reported a number of small early wins followed by larger and riskier investments: thus confirming the genesis mechanism, that of perceived informational advantage (overconfidence).
The sensation-seeking cycle was described as the patients' compulsive recovery of losses by investing, with higher frequency, in riskier financial instruments. This dependency-like behaviour of day traders did not start off with use of derivatives, but such instruments made an entry during the phase of recovering losses - suggesting that they provide the ever-higher reinforcement sought in a typical dependency.
The clinicians describe the 'magnification' of the patients' own skills to project themselves as a great investor, as well as reports of insomnia and psychostimulant use. The cycle in this dependency is further complicated due to trading being described as an escape from depression, boredom and anxiety. These harms of retail derivatives trading should give regulators pause and set in motion a meaningful regulation of the activity.
(Views expressed here are personal. Mohammed Shahid Abdulla is faculty member at IIM Kozhikode. Manoshij Banerjee is an independent consultant on digital culture and workplace)