Trading in a derivatives contract could be a negative-sum game against a popular perception that one of the parties will make money at the expense of the other. Brokerage fees, transaction costs, and taxes can eat up to 25% of your profits or add significantly to your losses.
The cost of trading Futures & Options (F&O) involves brokerage fees which account for 51% of the transaction costs, then exchanges take 20% and the government collects the remaining 29% as taxes, a Capitalmind Financial Services note said, informing that approximately 1 crore individual traders have contributed around Rs 50,000 crores in transaction costs over the past three years.
“When you buy or sell a derivative contract, the simple assumption is that either you or the counterparty will make money. However, this is not the case. It’s a negative-sum game. Brokerage fees, transaction costs, and taxes can eat up to 25% of your profits or add significantly to your losses”, said Nihit Kshatriya, Senior Research Analyst at Capitalmind Research.
Trading in derivatives is a complex business due to the unpredictable, erratic and random behaviour of the market forces and Capitalmind said that traders require better expertise, institutional knowledge, an experienced team and a technological edge to make money in this business.
Market regulator Securities and Exchange Board of India (Sebi) in a recently published study highlighted that 93% of Individual F&O traders lost money from FY22–FY24. In this period, 1.13 crore unique individual traders incurred a combined net loss of Rs 1.81 lakh crore in F&O.
The study further highlighted that more than 1 crore loss-making traders (92.8% of individual traders) lost an average of Rs 2 lakh per person in the F&O over three years. The top 3.5% of lossmakers or approximately 4 lakh traders, faced an average loss of Rs 28 lakh per person over the same period, inclusive of transaction costs.Only 7.2% of individual F&O traders made a profit over the period of three years of which only 1% of individual traders managed to earn profits exceeding Rs 1 lakh, after adjusting for transaction costs.The Sebi study revealed that most traders, regardless of capital size, incurred losses and the percentage of traders losing money doesn’t change with the amount of trading capital.
According to Capitalmind, this shows that trading a simpler instrument like futures, which typically depends only on the price of the underlying asset, gives one an advantage in a one-sided trending market.
Options, on the other hand, are complex as their movement depends on several factors like the price of the underlying asset, time to expiry, market volatility, and the invisible hand of the market.
While all the profits were made by proprietary firms and Foreign Portfolio Investors (FPI) through algorithmic trading, the data showed that some individual traders who used algorithmic strategies also incurred losses overall.
On this, Capitalmind opined that simply investing through an algorithm was not enough and the algorithm must be able to capitalise on market anomalies and inconsistencies to be profitable.
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