More than just speculation: The real purpose of derivatives
Derivatives often get criticized 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 in order to protect their portfolios, and some even aim to enhance returns with strategies that harness the volatility risk premium. Hedging is a globally well-known 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 often gets 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 hedging: An essential investment
Hedging is not free. It is like buying insurance—you pay a premium upfront for peace of mind. If we assess traders’ P&L solely based on their derivatives activity, without considering what they are protecting, then we are likely to misunderstand their actions. It is like saying, ‘90% of insurance buyers are losers!’ simply because they did not make a claim this year. It doesn’t capture the full picture.
A closer look at Sebi’s approach
Being a regulator, investor interest always reigns supreme for SEBI and therefore the regulator’s keenness to curtail speculations in the derivatives market is just. However, to suggest that ‘90% of retail traders are losing money because they are speculating!’ is perhaps ignoring a globally well-recognised risk mitigation practise of hedging.
Not every trader is in the market for speculation. Take calendar spreads on expiry days, for instance. These are hedged positions, designed to manage risk, not to make a quick buck. However, in the new proposed framework, unfortunately these are treated as speculative moves. One should certainly not be penalized for managing risk and for being cautious.
Moreover, SEBI’s analysis does not seem to account for traders with offsetting positions in equities or mutual funds. By clubbing everyone together, the reports might give the impression that all retail traders are just gambling which is definitely not true. To truly understand the level of speculation, it would be better to differentiate between those hedging and those speculating.
A call for a more balanced perspective
The derivatives market plays a dual role. Yes, it is there for speculation, but it is also a vital tool for hedging. The proposed move by the regulator will eventually lead to a drop in trading activities and trading volumes. A sharp drop in trading volumes will thus lead to hedging becoming more expensive and thus risk management also becomes more expensive.
A broader and balanced perspective of looking at derivatives market is essential now. To move forward, let us acknowledge that hedging might come with costs, but it is also a crucial part of long-term financial stability.
Looking ahead: The bigger picture
As we continue to discuss the future of India’s derivatives markets, it is important to keep the broader perspective in mind. Derivatives are not just tools for speculation, they are essential for managing risk. Ignoring the role of hedging could lead to regulations that might do more harm than good. A well-rounded approach that understands the various strategies in play, ensuring that the market remains both fair and robust for all participants is the need of the hour.
(The author is co-founder and CEO, AlgoTest. Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)