NSE's Derivatives Segment: Who Benefits from Recent Tweaks?

The National Stock Exchange halved market lot size for Nifty 50 along with other indices. According to experts, this is unlikely to impact the already moderating growth of volume or turnover. This comes after the bourse slashed its transaction charge by 1% across derivatives and cash products starting April 1—which experts said is miniscule to have a major impact.

"Premium/notional value may not change much, ideally, post the move as seen in the case of Bank Nifty lot size reduction in June 2023," said ICICI Securities in a note last week.

The Bank Nifty options notional and premium average daily turnover did not change much after the reduction in the lot size for the index last year.

“Notional value will not be much comparatively due to the rise in index levels. The value has increased significantly than that and trading at overall contract value—that may not lead to exponential growth in notional turnover, which could remain stagnant,” said Ruchit Jain, lead research analyst at 5Paisa.

Even, for traders, the profitability is expected to be limited.

"...those who can deploy margin can have multiple lot trades. This could be different for small traders with limited capital, leading to limited profitability," said Rajesh Palviya, head of technical and derivatives research at Axis Securities.

There was a notable rise in the participation of individual investors in the equity derivatives segment between FY16-FY21, which aligned with their increased trading activity in the capital market segment during the same period.

While their share of the equity derivatives turnover grew during the period, it has been on a consistently declining trend for the last three financial years.

Pre-Covid, it was the foreign institutional investors who were actively participating in the F&O segment, and now percentage of retail is among the highest in the client participation section.

“Retail participation interest has risen over the past years, but the percentage moderation is because of the high base as compared to previous years of low base," said Jain of 5Paisa.

The share of individual investors—which includes retail investors, individual domestic investors, HUFs—in equity derivatives reached the lowest in the last five years during December.

On a notional basis, it moderated to a five-year low of 25.7% during the month, resulting in an overall share of 26.8% as on Dec. 31, 2023—90 basis points lower than last year, as per data by the NSE.

“Derivatives universe is fixed and limited. New investors are more on the stock side; that is why turnover is stagnant. Once the market is sideways for some time, some may sway this way to play volatility during the uptick," said Palviya.

Although notional option volume grew at more than 100% year-on-year, a sharp decline in the premium-to-notional ratio has impacted premium turnover growth, analysts at IIFL Securities said in a note last month.

Premium turnover is on the contracts that get traded throughout the day whereas notional is the total value. Premium turnover is typically about a percent of the notional turnover.

The option premium turnover is up 26% YoY in FY24 vs 108% CAGR over FY20-23, as per an IIFL Securities note on March 26, which they believe is important as option revenue is dependent on premium turnover rather than notional turnover.

"A falling premium-to-notional ratio (41 bps in FY20 to 31 bps in FY23) has weighed on premium turnover in the past as well; but an acceleration in decline in the current year (down ~40% YoY to 19 bps) led to a sharp moderation in the premium turnover growth," the brokerage said.

The growth also depends on how much of the new participants engage in the segment as the investors' interest has remained stagnant in the last few months.

"Incremental trading from existing participants may not eventually lead to more engagement from them as they may not necessarily increase the lot. Therefore, notional value would remain the same, hence, exponential growth will not be seen initially. However, it can gradually pick-up based on the activity from new participants," said Jain.

The reduction of lot size will potentially lead to an increase in the number of orders, according to ICICI Securities. Hence, it could be construed as positive for brokerage plays.

How do brokers win? “Trading volume could increase for brokers as many discounted brokers charge based on the number of orders. Therefore, reduction of lot size may increase the number of orders, and that’s how brokerages benefit,” said Jain.

There could possibly be changes on the charges and some traditional brokers may look to reduce charges which needs to be watched out for. "Brokers sticking to the same charge is also a huge cost for traders. The ones who continue with the same cost will make more money," said Palviya.