The misunderstood role of derivatives in retail trading: a balanced perspective

Lately, there has been a lot of talk about how retailers in India derivatives Financial markets are struggling to become profitable. While reports focus on who is making money and who is not, let’s take a step back and understand why a trader uses a derivatives market in the first place. In this case, it is essential that we broaden our perspective. Derivatives are not just stand-alone instruments, they are closely related to the equity markets. If we only look at traders’ profits and losses in derivatives, we are missing a crucial part of the story, namely the importance of derivatives. coverage.

More than just speculation:The real purpose of derivatives

Derivatives are often criticised for promoting speculation. And yes, some traders do speculate, but there is another side to this. Many traders use derivatives to manage risk, not just to gamble. They hedge to protect their portfolios and some even seek to enhance returns with strategies that take advantage of the volatility risk premium. Hedging is a world-renowned tool used for effective risk management. Hedging strategies are designed to minimise the impact of any short-term correction in asset prices, but this aspect is often overlooked. Instead of focusing on the broader strategy, the conversation most of the time gets stuck on short-term gains and losses.

The cost of coverage: an essential investment

Hedging isn’t free. It’s like buying insurance: you pay a premium up front for peace of mind. If we evaluate traders’ profits and losses solely based on their derivatives activity, without considering what they’re hedging, we’re likely to misinterpret their actions. It’s like saying, “90% of insurance buyers are losers” just because they didn’t file a claim this year. It doesn’t tell the full picture.

A closer look at Sebi’s approach

Being a regulatory body, the interest of investors always reigns supreme for SEBI and hence the regulator’s interest in limiting speculations in the derivatives market is fair. However, suggesting that “90% of retail traders are losing money because they are speculating” is perhaps ignoring a globally recognised risk mitigation practice – hedging.

Not all traders are in the market to speculate. Take calendar spreads on expiry days as an example. These are hedged positions, designed to manage risk, not make a quick buck. However, under the proposed new framework, they are unfortunately treated as speculative moves. Surely, no one should be penalised for managing risk and being cautious.

Moreover, SEBI’s analysis does not seem to take into account traders with offsetting positions in stocks or mutual funds. By lumping everyone together, the reports could give the impression that all retail traders are simply gambling, which is definitely not true. To truly understand the level of speculation, it would be better to differentiate between those who hedge and those who speculate.

A call for a more balanced perspective

The derivatives market serves a dual function. Yes, it is there for speculation, but it is also a vital tool for hedging. The measure proposed by the regulator will eventually lead to a drop in trading activities and trading volumes. trading volumes This will make hedging more expensive and therefore risk management more expensive.

It is now essential to take a broader and more balanced view of the derivatives market. Moving forward, let us acknowledge that hedging may have costs, but it is also a crucial part of long-term investing. financial stability.

Looking ahead: the bigger picture

As we continue to look at the future of Indian derivatives markets, it is important to keep a broader perspective in mind. Derivatives are not just tools for speculation but are essential for managing risk. Ignoring the role of hedging could lead to regulations that could do more harm than good. The need of the hour is to adopt a comprehensive approach that understands the various strategies at play and ensures that the market remains fair and sound for all participants.

(The author is co-founder and CEO of AlgoTest. The recommendations, suggestions, views and opinions of the experts are their own and do not represent the opinions of the Economic times)