Why New F&O Traders Face Massive Losses

The recent report released by SEBI (Securities Exchange Board of India) on the Analysis of Profits & Losses in the Equity Derivatives Segment (FY22-24) highlights significant risks associated with F&O trading for individual investors, particularly those with nil to limited experience or knowledge of the financial markets.

1. Lack of Experience and Market Knowledge:

New traders often enter the F&O market without a solid understanding of the complexities involved in derivatives trading. Futures and options (F&O) require an understanding of market timing, volatility, and leverage, which many new traders lack.

High-risk exposure: Derivatives trading involves substantial risk, and inexperienced traders may not be aware of how quickly positions can move against them, leading to heavy losses.

2. Over-reliance on Options Trading:

Product preference: Nearly 99.3% of F&O traders traded options, a more volatile and speculative product, compared to futures.

High loss rate in options: In FY24, 91.5% of options traders incurred losses, compared to only 60% in futures. The complexity and risk of options, especially for inexperienced traders, lead to frequent poor outcomes.

3. Poor Risk Management:

Lack of risk controls: Many traders fail to employ appropriate risk management techniques like stop losses, position sizing, or hedging strategies. This exposes them to significant losses, particularly in a market that can be volatile.

Leveraging: Derivatives allow traders to take large positions with a small capital base, which magnifies both gains and losses. Many traders underestimate the risks associated with leverage.

4. High Transaction Costs:

Transaction costs: New traders often underestimate the impact of transaction costs such as brokerage fees, exchange fees, and taxes (e.g., STT, GST, stamp duty). These costs can significantly erode profits or deepen losses.

The report highlights that transaction costs amounted to ?50,000 crore from FY22 to FY24, with new traders bearing a significant portion of these costs. On average, traders spent ?26,000 per person on transaction costs in FY24 alone, further contributing to net losses.

5. Frequent Trading and Speculation:

High-frequency trading: Many new entrants engage in speculative, high-frequency trading without a long-term strategy. The increase in the number of transactions per person (870 transactions on average in FY24) often leads to hasty and emotion-driven decisions.

Speculative mindset: Instead of using derivatives for hedging or strategic purposes, many retail traders speculate on short-term price movements, further exposing themselves to high risks and frequent losses.

6. Algo and Institutional Traders' Advantage:

Disadvantage against algorithmic trading: The report shows that institutional traders (like FPIs and proprietary traders) heavily rely on algorithmic trading, which gives them an edge in speed, precision, and execution. 97% of FPI profits and 96% of proprietary profits came from algorithmic trades in FY24.

In contrast, only 13% of individual traders used algorithmic trading, putting them at a competitive disadvantage, especially in a market where speed and execution can be critical.

7. Psychological Factors:

Persistence despite losses: Over 75% of loss-making traders continued trading despite making consistent losses over the past two years. This reflects a psychological tendency to continue trading in hopes of recouping losses, often leading to even greater losses.

Overconfidence and lack of discipline: Many traders tend to be overconfident in their abilities to predict market movements, leading to impulsive decisions and inadequate risk assessments.

8. Misjudgment of Market Volatility:

Volatile nature of the F&O market: The F&O market is highly volatile, with rapid price fluctuations. Traders, especially those new to the market, often misjudge the degree and direction of volatility, leading to wrong bets and significant losses.

Underestimating time decay: For options traders, time decay (the loss of value in options as they near expiration) is often misunderstood or ignored, leading to substantial losses, particularly for traders who hold options too long.

In conclusion, the primary reasons for losses among individual F&O traders, especially new entrants, include a lack of experience, poor risk management, high transaction costs, over-speculation, and a competitive disadvantage against algo and institutional traders. Better education on derivatives trading, risk management practices, and reducing speculative tendencies could help mitigate these losses.

Please do share your thoughts on this topic in the comments section and to continually get access to my other articles - Subscribe on LinkedIn https://www.dhirubhai.net/build-relation/newsletter-follow?entityUrn=7018962394668306433