Keep the option open

 My recent interactions with many market participants indicated that selling deep Out of Money (OTM) options (mostly Call Options) on the last day of the weekly option expiry days (e.g., Wednesday for Nifty Bank and Thursday for Nifty50) has become a very popular trading strategy for many high networth individuals (HNIs). By pledging stocks, mutual funds, and bank deposits as margin money, HNIs claim to be enhancing their overall returns by 6% to 8% p.a. using this trading strategy.

Surprisingly, most brokers and money managers, who run this strategy for their clients, are selling this as a risk-free strategy arguing that a move of 5% of more in Nifty50 or Bank Nifty on the expiry day is unlikely. An option of strike price 5% away from the current index value will hence expire worthless.

There are three points to be considered in this regard, in my view.

1.    In recent years we have not witnessed large (5% or more) daily moves in benchmark indices. In fact, we have hardly seen moves of more than 3% on a daily closing basis in the past 5 years. Nonetheless, terming this strategy as risk-free is highly inappropriate. During 2007-2013 there were more than 40 daily moves of 5% or more. There were more than five daily moves of 10% or more in Nifty during that period. Under the present global economic and geopolitical conditions, it would be unreasonable to completely rule recurrence of multiple large moves.

Considering that the premium earned on selling deep OTM options on the expiry day is minuscule, theoretically, a sudden large move can negate years of earnings in one single day.

2.    The composition of market activity in India has materially changed since the global financial crisis days when 3-5% daily moves in the index were not uncommon. In FY08, before the global financial crisis, the single stock futures (inarguably the riskiest derivative product) comprised 58% of the total derivative segment turnover, whereas the safest product index options were just 10%. In FY23 Index options were 97.7% of the derivative segment turnover, while stock futures were just 0.5%. Obviously, the systemic risk is now minimal. The potential losses are very well defined and adequately provided for through stringent margins.

3.    The rise in popularity of option trading presents a moral dilemma for the regulators. No prizes for guessing that the counterparty to the OTM options sold by HNIs in their trading strategy are mostly small traders for whom an OTM option is nothing but a lottery ticket.

As per a Bloomberg report, in 2023, Indians traded a whopping 85.3 billion options contracts. No other country trades such humongous volumes of options contacts annually, not even the United States (US). For perspective, in 2023, the United States traded 11.2 billion options contracts, while Brazil traded only 2.4 billion contracts, and the data from the rest of the world is almost comparatively negligible. In India, 35% of options trades are done by small (retail) traders.

As per a Securities and Exchange Board of India's (SEBI) January 2023 study, 90% of active retail traders lose money trading options and derivative contracts. As per the latest available data, these small (retail) traders collectively lost $5.4 billion (nearly Rs 44,848 crore) in trading options in the year ending March 2022. On average, loss makers registered a net trading loss of close to ₹50,000.

Unlike most western and Asian countries, in India, there are very few legal avenues for betting. Only nine states in India permit legal lottery business. Other legal betting avenues like horse racing, casino etc. are also accessible to a limited proportion of population (mostly HNIs). Under these circumstances, “betting” on options is the most convenient alternative available to people who aspire to become rich “by luck”.

The dilemma for regulators is whether they should keep this avenue of betting open with adequate safeguards, or close it for small traders, just like the lottery business was banned in many states during the 1990s.

In my view, the regulator should keep this option open with due safeguards, lest the aspirants may be forced to resort to illegal/unregulated means and lose even more.