If you are an avid investor, you must have some idea about the capital market, stocks and trading instruments. What if you get a chance to speculate about how much a stock will value, say, after a month and get to make a large profit in a short time? This must sound tempting, right? But it is exactly this growing involvement of retail investors in trading that has India’s market regulator worried.

At the heart of the issue is trading in “futures and options” (F&O) derivatives. The F&O segment is extremely volatile, to say the least—which means either big profits or heavy losses. In the 2023-24 fiscal, about 9.25 million investors suffered a loss of Rs 51,689 crore (about $6 billion) during derivatives trading on the National Stock Exchange. To combat this, the Securities and Exchange Board of India last week altered the norms guiding the entry and exit of stocks into the segment.

“This step helps shield retail investors from extreme price swings and market manipulation, while also improving how well prices are determined and how smoothly the market functions,” says Sagun Agrawal, founder of Dhan Diksha, a Kolkata-based financial literacy platform.

This explainer is an attempt to understand what these new norms are and how exactly they will help protect retail investors. Before that, let’s quickly look at what F&O derivatives are.

The basics: Derivatives are financial instruments (like stocks and bonds) that derive their value from an underlying asset. Futures and options are the most popularly traded derivatives. Futures are financial agreements between two parties to buy or sell an asset at an agreed price and date in the future. Options are agreements where an investor has the right, without any obligations, to buy or sell an asset at a predetermined price and date in the future.

These instruments are mainly used by seasoned traders to earn profit or hedge against losses.

In recent years, many amateur investors have been engaging in F&O trading to make a fast buck, thanks to easy access to trading apps and the deluge of “finfluencers”. According to a study published by SEBI last year, there were about 4.52 million unique individual traders during 2021-22, with 89% (nine out of 10) of them incurring losses in equity options. In 2018-19, however, there were only 710,000 such traders, 85% of whom suffered losses.

Enter SEBI: The regulator has, on multiple occasions, expressed concern over the dramatic growth in such trades. SEBI’s recent changes are aimed at making sure that only the strongest stocks—in terms of liquidity, size and market depth—are allowed in the derivatives market.

Now, out of the four criteria that stocks must meet to enter the derivatives segment, SEBI has tweaked three.

First, the new guidelines state that the stock’s market wide position limit (MWPL), over the period of previous six months, on a rolling basis, shall not be less than Rs 1,500 crore (about $178 million), as against the existing Rs 500 crore. MWPL is the maximum number of open F&O contracts permitted for a particular stock.

“SEBI raised the MWPL to better align with the growing size and liquidity of the market. This change aims to strike a balance between keeping the market stable and giving traders the room they need to execute strategies effectively,” says Agrawal.

However, sometimes the MWPL, as it stands, can restrict traders when stocks hit the 95% limit and enter a ban period. During this time, new positions can't be opened, which can disrupt certain trading strategies, like hedging. The latest tweak also addresses this. “By increasing the MWPL, SEBI reduces the chances of stocks entering this ban period as frequently, giving traders more flexibility to continue their activities without constant interruptions,” says Agrawal.

Second, SEBI has raised the average daily delivery value (ADDV) in the cash market, in the past six months, on a rolling basis, to at least Rs 35 crore ($4 million) from Rs 10 crore. ADDV is the average daily value of delivery-based trades in a stock, where the buyer actually takes delivery of shares into their demat account.

It’s well known that stocks with lower delivery volumes or smaller market capitalization are more vulnerable to price manipulation. “By raising the ADDV, SEBI ensures that only stocks with regular, substantial trading activity in the cash market are eligible for derivatives trading,” says Agrawal.

Third, the stock should have a median quarter sigma order size (MQSOS) of at least Rs 75 lakh (about $90,000), over the previous six months, on a rolling basis—up from Rs 25 lakh. MQSOS refers to the order size in the market. A higher threshold will ensure that only stocks with substantial activity will enter the derivatives market.

Finally, no changes have been made to the average daily market capitalization and average daily traded value. The stock needs to be among the top 500 in the previous six months on a rolling basis.

Fate of the stocks: A stock in the derivative segment will exit if it fails to meet any of the stated criteria for a period of three months on a rolling basis based on its previous six months’ data. However, the existing contracts are permitted to continue till they expire. Once a stock exits the segment, it will have to wait for another year before being considered for inclusion.

The regulator will be scanning only those stocks which have completed at least six months in the segment. Additionally, a three-month gestation period will be given to the existing stocks before the exit norms are applied.

Note that by the end of 2023-24, there were 182 stocks available for trading in the F&O segment. And once the norms are implemented, about 26 stocks could exit and 35 could enter.

“This could pave the way for Zomato and Jio to enter the Nifty 50 in the March 2025 review. The real excitement kicks in if F&O inclusion for both these names happens within the next few months," Abhilash Pagaria, who heads Nuvama Alternative, told The Economic Times.

The brokerage firm, according to the ET report, expects the inclusion of 80 stocks in the segment in the coming year and exclusion of 18. Among those likely to enter the F&O segment are large stocks like Jio Financial, LIC, BSE, Avenue Supermarts (DMart), Adani Green, CDSL, Macrotech Developers (Lodha), Angel One and Yes Bank. Apart from these, Zomato, PB Fintech (Policybazaar), Delhivery, Paytm and Nykaa are also expected to make it to the list.

However, Abbott India, Metropolis Healthcare, Gujarat Gas and Can Fin Homes, among others, could be on their way out, the ET report mentioned.

Overall, SEBI’s move has been welcomed by experts. “It is a smart move,” says Agrawal. “By adjusting the eligibility criteria of stocks to fit the current market environment, SEBI is working to keep the derivatives market efficient, liquid and secure for everyone. This update should boost investor confidence and help the Indian securities market to keep growing.”

Bottom line: as its multiple warnings are not keeping retail investors away from speculation, the regulator has now moved to make the F&O segment at least a bit less risky and volatile for them.

Cover image from Canva