is the indian stock market becoming a casino
Indian equity markets have seen a significant transformation in recent years. It is becoming more and more accessible and efficient. Our economy is also doing great! Inflation is in control, the growth forecast is robust, credit demand is high, NPAs are low, the unemployment rate is at a six-year low and SIP inflows are at an all-time high. Even the government is trying its best by making policies favourable for domestic and international companies to grow the economy.
India is expected to grow at the fastest pace among large economies. And equity investing is one of the best ways to participate in this growth story. However, equity investing demands hard work and discipline. You have to analyze the growth prospects of the companies along with the risk they carry and then invest at a favourable valuation. And after doing everything right, your patience will be tested in some cases. And that is why it is not for everyone.
But it seems like many new retail participants are in the stock market to make a quick buck. However, as legendary investor Mr. Warren Buffet has said: “The stock market is a device for transferring money from the impatient to the patient.”
In the stock market, there are various types of instruments. For example, you can buy and sell stocks in the cash market. In this, you can generally get 5-10x leverage on intraday positions. Some brokers also allow similar leverage in deliveries as well. Then comes the derivatives contracts (future and options as we know it). Here the leverage (and in turn risk) is very high and payoffs can be nonlinear.
Now, in the Indian stock market, equity derivatives account for a staggering 99.6% of market volumes, totaling over US$4.3 trillion per day! Let’s compare this with the cash market trading. Derivates volumes are whopping 422 times the cash equity trading volumes and 900 times the delivery volumes (let that sink in!).
And this number is the highest in the world. Below is the comparison of derivative volume to cash volume ratio of different countries.
The number is more than 10 times that of Germany, which has the second-highest value of this ratio. And this is seriously concerning because derivative contracts were made to facilitate hedging and reduce risks. But now they are used as a tool for taking the risk.
Change in contract structure and leverage, combined with new-generation trading apps has triggered gamification. This has in turn has fueled the growth of derivative traders.
In 2019, derivative traders in India were less than 5 lakh. Now the number has crossed the 40 lakh mark. Why? There are multiple factors at play. The primary factor is the inherent leverage. You can take a huge position with a fraction of the cost. This can result in non-linear payoffs. Also, the alignment of expiries in key indices to different days of the week now facilitates zero-day expiries. Every trading day of the month there is at least one expiry of key indices.
That is why index options dominate the derivative market, accounting for 99% of trading volumes, and among them, weekly options make up 95% of the transactions. On the day of expiry, index options offer an effective leverage of 500 times, which is attracting retail traders. A mere investment of Rs. 2,000 in an option provides exposure worth Rs. 10 lakhs. Also, most of the trading by retail traders is for speculative bets as the retail traders typically hold their options for an average of only 30 minutes!
In the last four years (particularly during the COVID era), leading online platforms saw their active client base grow multifold to 1.8 cr. More than 50% of the new clients are from tier-2 and tier-3 cities. Similarly, more than 50% of the new participants are below 25 years of age.
Many of them do not understand the risks involved in the derivative markets. With high leverage, you can lose 40-50% capital in a day. And with at least one weekly expiry every single day, derivatives contracts are becoming tools for speculation rather than hedging. For example, around 45% volume of a weekly option contract of Nifty and Bank Nifty comes on the expiry day. For Sensex contracts, this number is above 90%.
And retail traders are bleeding. A recent SEBI report highlights that 9 out of 10 traders lose
money, with ~Rs. 56,000 loss per person on average. And as per a recent SEBI study in FY22, retail traders on aggregate lost more than 80% of their bets (Rs. 45,000 cr was lost by 90% of participants while 10% of the participants earned Rs. 6,900 cr). Compare this with fantasy sports. Companies operating in that space keep 15-16% of the total bet for them and return 85% of the total amount back to participants!
We believe that India as an economy is well set to fire on all cylinders. As mentioned in the beginning, almost all the macro factors are positive and the outlook is extremely robust. We as an investor can benefit from this opportunity by investing in capital markets.
We strongly feel that the Indian stock market will generate immense wealth for investors in the next decade. But to become a successful investor, we have to understand the inherent risks. We should not waste this opportunity by losing our hard-earned capital in speculative trading.
In the world of investing, discipline differentiates good and bad investors. If you do not have the time or knowledge to actively invest in stocks, you should invest passively with mutual funds and ETFs. And that is why on sharpely, we have created low-cost, data-driven Index funds and ETF baskets for retail investors. You can explore them here.
Derivative contracts are interesting instruments. They can provide a hedge by allowing you to transfer the risk to someone who is willing to take it. On top of that, they provide additional liquidity in the markets. But with the recent rise in retail derivative traders (and many of them being very young) and volumes, it becomes extremely important to understand the risk of these instruments. Due to their very high inherent leverage, derivatives can wipe out your capital in a very short time. With the expectations of our economy doing well in the coming years, we believe that informed and disciplined investing is the only way to create wealth.
Source: “Gamification” of Indian Equities by Axis MF Research