Samco’s Nilesh Sharma Explains: How Hedging Can Help Traders Tackle Soaring Margins Amid Proposed SEBI Rules

The derivatives segment of the Indian markets has been one of the most dynamic sections in recent years. Retail investor activity soared to an all-time high and many individual traders flooded into the F&O segment with high hopes of profitability. However, the reality was starkly different from expectations.

Around 90% of retail F&O traders suffered losses in FY22. This was not a one-time complication, either. The trend of F&O losses in the retail segment has persisted year after year, with the total losses by individual traders surpassing Rs. 50,000 crore in FY24.

These numbers from SEBI's reports have triggered the alarm for many months now. The market regulator and the Indian government recently stepped up to the growing concerns of F&O losses in the retail segment. While the government proposed to increase F&O taxation to curb speculative activity, SEBI has rolled out a 7-step plan to strengthen the F&O framework in India.

Nilesh Sharma, ED & President of Samco Securities, breaks down the new SEBI rules proposed.

"SEBI's proposed seven-point strategy for the F&O market is a significant step towards addressing the concerns of retail investor losses and market stability. The rationalisation of options strikes and weekly index products could help concentrate liquidity and reduce excessive speculation.

Intraday monitoring of position limits and the removal of calendar spread benefits on expiry day could also lead to fairer market conditions. While the increase in minimum contract size might initially seem challenging for some retail traders, it could result in a more stable market with reduced volatility.

The upfront collection of option premiums and increased margins near expiry may also create a more responsible trading environment. This could potentially protect retail investors from overexposure and create a more transparent and efficient derivatives market."

However, the issue of increasing margins has been a pain point for F&O traders, especially those with tighter trading budgets and limited liquidity.

What the New SEBI Rules Say About Increasing Margins

This proposed new SEBI rule aims to reduce speculation and risk in the F&O segment. More specifically, the Extreme Loss Margin (ELM) may be increased by 3% on the day before expiry and by an additional 5% on the expiry day. Since this new SEBI rule may apply to both futures and options selling positions, it effectively raises the overall margin required to maintain positions near expiry.

The market regulator has also suggested that the minimum contract sizes be increased and the options premium be collected upfront. These measures all aim to curb excessive leverage and speculation - especially during the volatile trading sessions near the expiry days.

Despite noble intentions, the change may be challenging because the margin increases that could result from the proposed new SEBI rules may be substantial. Experts estimate a 30-40% reduction in F&O volumes if these rules are implemented.

Why This Concerns Retail F&O Traders

The proposed new SEBI rules have retail F&O traders worried because the increased margin requirements, particularly the ELM hikes near expiry, could tie up significantly more capital. This, in turn, could heavily impact the profitability and participation of retail F&O traders in India. Traders with limited funds may struggle to maintain positions and be forced to scale back or exit their traders altogether.

The suggested increase in the minimum contract sizes by 3-4 times over six months further amplifies the burden on trading capital. Smaller traders may find themselves priced out of the F&O segment altogether. Even for those who can afford to trade, the twin forces of higher costs and reduced leverage may lead to diminished profitability.

The increased cost and complexity may prevent many smaller traders from participating in the derivatives market. Retail traders are concerned that the new SEBI rules suggested disproportionately impact them when compared to institutional investors.

Hedging Options Trades: An Effective Response to the New SEBI Rules

Amidst this prevailing wave of concern, Samco's Nilesh Sharma has a simple yet effective solution for retail traders who are still keen on F&O trading but do not want to suffer the burden of additional costs. As Sharma explains, the key lies in hedging. When used effectively, this technique can help small-time traders navigate the suggested new SEBI rules successfully.

The recent unwinding of the yen carry trade shows the importance of hedging in an uncertain market. Triggered by the Bank of Japan's unexpected interest rate hike, this incident sent shockwaves through global financial markets as the yen rapidly appreciated. While some sophisticated investors, such as hedge funds, may have employed hedging strategies to mitigate their currency risk, many others were caught off guard by the sudden market movement.

Large hedge funds frequently employ the yen carry trade by borrowing in low-interest rate currencies like the yen and investing in higher-yielding assets abroad. However, they are keenly aware of the currency risks involved. To safeguard their positions, these funds often use hedging strategies such as currency options, forwards, and swaps.

Decoding Hedging Strategies for F&O Traders

With the possible new F&O rules likely to strain the capital and profitability of retail F&O traders, hedged strategies emerge as a viable solution. Many approaches are available to traders interested in keeping pace with the new dynamics.

• Pairing Long and Short Positions

By pairing long and short positions, traders can create spreads that limit the downside exposure. For example, buying a call option while simultaneously selling a higher strike call forms a vertical spread. The premium collected from the short leg helps fund the premium required for the long leg. This reduces the net capital outlay.

• Diagonal Spreads

Diagonal spreads, which involve options with different strike prices and expiry dates, offer another effective hedging avenue. By selling a near-term option and buying a longer-term option, traders can mitigate time decay while also benefiting from potential price changes. Here, the longer-term option acts as a hedge against adverse market shifts.

• Delta-Neutral Strategies

Delta-neutral strategies like straddles and strangles involve simultaneously purchasing or selling both call and put options at the same strike price (straddles) or at different strikes (strangles). These strategies may require higher initial capital but traders can profit from significant price moves in either direction while also limiting the risk.

• Hedging with Futures

Hedging with futures contracts is another possible way to ensure the new SEBI rules do not burden trading capital too much. By taking an opposing position in the underlying asset or in any correlated security, traders can offset potential losses from their options trades. However, this approach may require better exposure management.

Options Hedging Simplified with Samco's Options B.R.O

Hedging has always been recommended for retail traders, but with the proposed new SEBI rules on the horizon, traders now have the opportunity and the incentive to make the shift towards more responsible trading with hedged strategies. Nilesh Sharma tells us how Options B.R.O, Samco's advanced options strategy builder, can be instrumental in helping trades make this change.

"Samco's Options B.R.O is designed to take the stress out of live market trading. Manually deploying option strategies can be overwhelming for traders, especially when they are trying to keep up with market fluctuations. But with Options B.R.O, traders can automate complex option hedging strategies with just a few clicks.

This advanced tool simplifies hedging by allowing traders to implement multi-legged strategies with just a few clicks. Instead of being bogged down in the intricacies of each trade, Options B.R.O from Samco Securities helps traders design, test and execute hedging strategies in real-time."

About SAMCO Securities

SAMCO Securities was incorporated by Mr Jimeet Modi, Founder & CEO of SAMCO Group in 2015. As the country's leading flat-fee brokerage and wealth-tech platform, SAMCO Securities provides retail investors access to sophisticated financial technology and makes their wealth-creation journey simple, informed, and cost-effective. SAMCO Securities' mission is to eliminate the existing challenges faced by traders and investors and democratise access to the wealth management process for every Indian. With customer centricity at SAMCO's core, we implement a quantitative approach to provide differentiated solutions that empower our customers in acing the capital markets.

SAMCO Securities is pioneering the stock market trading by introducing industry-first features like My Trade Story, Personal Index and Trade Spread Sheet to name a few under its CRP strategy.