F&O Trading Could Get Even More Taxing!
Pun Intended.
Budget season is here.
Our Union Budget will be presented in the Parliament sometime in July.
And as usual, market pundits have to make predictions.
I sometimes feel they do this to just stay relevant and in the news.
But hey, who am I to question their intent? They sometimes end up being right!
So, their latest “prediction” is around possible tweaks to the regulations on derivatives trading (Futures and Options or F&O) in India.
Particularly around potential tax hikes.
If you are a novice - you can jump to “Noob’s Corner” where I have explained what derivatives trading really is. If you know, please continue reading.
The Concerns
Stock markets in India have seen a big rally. The good news? Penetration is increasing. Lakhs of demat accounts are being opened every month. A lot of small retail investors have entered the market.
Around 3.5 Crore active NSDL Accounts belong to Resident individuals, making up 97.5% of the total 3.6 Crore active accounts. From 31st March to 30th April, there were ~2,77,000 accounts added. In value terms, of course we are still small. But growing.
“Total number of Demat accounts in India has reached a new high of 15.1 Crore as of March 2024. There was a significant increase in new Demat account openings in March 2024, with 31 Lakhs new accounts added.” - Business Standard
So yeah, lots of accounts opened.
The bad news? Without the right understanding, the right experience, the newbies might just lose a lot in the markets. And they are.
You see, markets are addictive. The high of winning when you are right is crazy. Lots of dopamine. And for someone who has tasted early victory, it’s easy to fall into the trap of assuming they know a lot. Assuming that their skills are better than they actually are.
And with false confidence, we start taking more risks. We start losing a lot.
Here’s what SEBI had to say about this:
To curb this, pundits are predicting that the government might raise taxes. Higher taxes could mean increased costs for traders, potentially making trading less profitable.
My opinion - won’t matter much to the ones who are already addicted. Some just come back to the markets to experience the highs missing from their lives. They don’t care what the tax structure or costs are.
They will do it if they want to do it.
Till they run out of money, of course.
And then they will borrow and do it.
Sad, but true.
And it’s not the first time that the government may do this. In the past, the government has done a lot of things to “regulate” and “control” this sector better.
Back in 2015, they increased the contract size. The minimum size was increased from ₹2,00,000 to ₹5,00,000. This made it more expensive for retail investors to trade derivatives.
Then In 2017, they introduced some margin structure changes. Additional margins were imposed during high market activity. This increased the costs for traders when market-wide positions hit certain limits.
But despite these changes, the derivatives market has continued to grow. And it’s BIG!
Largest derivatives exchanges worldwide from 2020 to 2023, by number of contracts traded (In Millions)
Today, NSE is by far the largest derivatives exchange in the world.
As per Statista, NSE traded over 84 billion contracts in 2023, followed by the Brazilian B3 with 8.3 billion. NSE volume is basically 10x more than the next best.
Anything adverse that happens in this space can make a lot of folks nervous. Stressed. And hence, predictions are coming in around it.
The Predictions
Here’s a breakdown of what all may happen in the upcoming Budget Session:
Tax Hike for Big Players: Large institutions that use high-frequency trading (HFT) and algorithms might face higher taxes. They already have an advantage over small retail investors. Even a small increase in taxes could affect them big due to their large trading volumes.
Tax Hike for Futures: Futures might see higher taxes compared to options. This is because futures have a linear payoff, meaning gains and losses can be equal. Options, on the other hand, have predefined maximum losses with theoretically unlimited gains, making them slightly safer for retail traders.
Exposure Limits Based on Net Worth: Rumours suggest that the maximum exposure for retail traders might be linked to their net worth or previous tax payments. This would likely apply to futures and options writing (selling) and probably not buying. This one also makes sense. People will refrain from borrowing to trade.
Why This May Not Happen
It’s easy to jump to conclusions.
We do it so often in life.
Without knowing all the facts, we pass judgements.
I guess that’s human nature.
With these predictions too - let’s not get ahead of ourselves.
Let’s remember that the government collects a lot of revenue from the Securities Transaction Tax (STT) on trades.
They wouldn’t want to completely stifle derivatives trading and lose this income.
Maybe linear instruments like Futures might face new restrictions or higher taxes. But options buying might remain unaffected.
This could push more retail traders towards buying options, increasing their premiums and potentially benefiting those who sell options. Options selling requires significant capital due to margin requirements, so this might favour deep-pocketed traders.
We'll know more once the budget is announced.
For now, keep these possibilities in mind and stay prepared.
No right answers
The potential changes to F&O trading regulations remind us to look at both sides of the coin.
Idea is to keep a delicate balance between keeping things regulated and allowing market freedom.
Higher entry barriers and taxes could edge out smaller traders, giving an advantage to those with more money.
This might make the market more stable but also raises concerns about fairness and inclusivity.
Shouldn't everyone have access to financial markets, or is some level of exclusivity needed for stability?
I don’t have any firm answer to this. I would love to hear your views. You can send them to me on shantanu@readon.in.
Noob’s Corner
Derivatives Explained
A derivative is simply anything that derives its value from something else. Like this piece. It’s a derivative of some gyaan some expert gave in some business newspaper.
So, in the world of stock markets, derivatives derive their value from underlying stocks. They come in two variants. Futures and options. Both instruments allow you to bet on the future. If you want to read about these in detail, Varsity by Zerodha is a good resource.
Let me quickly tell you the difference between Futures and Options: this will help you understand which one feels riskier and you can then understand what follows better.
See, futures don’t “cost” you anything, it’s a simple betting instrument where you can take a punt on the direction and value. For example, you feel a stock trading at Rs. 100 will go to Rs. 150 in the next 6 months. If you buy a Rs. 100 future, and the stock closes at Rs. 140, you make Rs. 40. But if it (say) closes at Rs. 50, you lose Rs. 50.
This is not the case in an Option. An option gives you the right to buy/sell a particular stock at a predetermined price at a later date.
So if you want to punt on the upside of this stock, you can take a right to buy this stock at a later date at Rs. 100. The option writer (seller) charges you a premium to give you this “right to buy.”
If the price is Rs. 150 after 6 months, you make Rs. 50 minus the premium you paid (say Rs. 5). But if the price is Rs. 50 after 6 months, you can choose to not exercise your right (option), and you just lose the premium you paid (Rs. 5).
Did you see what just happened?
By choosing an option over futures, your downside was limited, but your upside could be huge. With Futures, you would have to bear the full loss of the downside as well.
This is a super simplistic explanation - a lot of other factors are also at play - but this is the gist of it. You can now go back to the top and read about what predictions are being made.
If you want to dive deeper in derivatives, you can check out Varsity by Zerodha. They have done a really good job at detailing stuff out and made it available for free :)
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Can you send the link to Noob's corner