Starting November 20, 2024, the Securities and Exchange Board of India (SEBI) will implement three significant measures to reform equity index derivatives, commonly known as futures and options (F&O). These changes, part of a broader six-point framework unveiled last month, aim to foster stability, protect retail investors, and curtail speculative trading in the derivatives market. Here’s an in-depth look at the key reforms set to take effect and their potential implications.

1. Recalibration of Contract Size for Equity Derivatives

What’s Changing?
SEBI is increasing the minimum contract size for index futures to ₹15 lakh, with a review target to ensure the value lies between ₹15 lakh and ₹20 lakh. This recalibration will apply to all new contracts introduced post-November 20, 2024.

Implications:

• Impact on Retail Traders: Smaller retail investors, who account for 40% of F&O trades, might find it challenging to meet the higher margin requirements, leading to a potential reduction in their market participation.
• Shift Toward Institutional Players: Institutional investors, contributing 60% of market turnover, are expected to fill the liquidity gap created by retail exits.
• Market Stability: By reducing speculative trading, the measure aims to align market participation with risk appetite, safeguarding retail investors from heavy losses often driven by high-risk trades.

HDFC Securities’ Chief Strategy and Transformation Officer, Kunal Sanghavi, remarked that the move could protect retail investors from unsustainable losses, especially those seeking overnight gains.

2. Rationalisation of Weekly Index Derivatives Products

What’s Changing?
Currently, multiple exchanges offer short-tenure index contracts with weekly expiries, leading to speculative and hyperactive trading. Under the new rule, each exchange will be permitted to offer weekly derivatives for only one benchmark index.

Implications:

• Moderating Speculative Trades: Weekly options, which account for 70% of index derivative volumes, are dominated by speculative trading. Limiting weekly contracts to one index per exchange is expected to reduce excessive risk-taking.
• Impact on Options Sellers: The single-index expiry regulation will discourage naked (unhedged) options selling, as fewer opportunities will now be available for speculative plays.
• Stability for Retail Investors: Nearly 90% of speculative retail trades in weekly options reportedly end in losses. By limiting choices, SEBI aims to create a more constructive trading environment.

According to Whitespace Alpha’s Sharma, this move could slow the explosive growth of speculative trading, protecting retail investors from undue financial risks.

3. Increase in Tail Risk Coverage on Expiry Days

What’s Changing?
To address extreme market volatility on expiry days, SEBI has mandated an additional 2% Extreme Loss Margin (ELM) on short-options contracts.

Implications:

• Higher Margin Requirements: Traders with aggressive expiry-day positions will now face increased upfront costs, discouraging speculative high-risk bets.
• Reduced Expiry-Day Volatility: Expiry sessions, known for sharp price movements, will likely see moderated fluctuations. Past data indicates peak-day retail losses during expiry have exceeded ₹1,000 crore in some months.
• Risk Mitigation for Rare Events: By enhancing tail-risk coverage, the measure aims to protect the market from extreme losses caused by rare but severe events.

Whitespace Alpha’s Sharma highlighted the potential for this reform to significantly reduce the financial impact on retail investors during volatile expiry sessions.

Looking Ahead

While these three measures will take effect immediately, the remaining three reforms in SEBI’s six-point framework are slated for implementation next year. Together, these changes represent a critical step toward creating a more resilient and investor-friendly derivatives market.

Market experts anticipate a short-term dip in liquidity as participants adjust to the new norms. However, the long-term benefits—such as reduced speculative activity, enhanced market stability, and better alignment of risks with investor profiles—are expected to outweigh initial challenges.

As India’s equity derivatives market navigates these transformative reforms, stakeholders, particularly retail traders, should reassess their strategies and risk management practices to adapt to the evolving landscape.