Compensate for risk

Retail investors suffered huge losses in futures and options (F&O) segment, evident from a SEBI study. Will it help if retail investors are prevented from taking exposure to risky instruments? Here, we discuss why such measures may not always be the optimal answer to helping such market participants.

Risk compensation

Individuals arguably adjust behaviour to maintain a relatively constant level of perceived risk. This is referred to as the risk homeostasis theory. In other words, if an action we take is made safer, we may be tempted to be more aggressive the next time we engage in such action to compensate for the now lower risk.

Risk compensation is debatable. Suppose automobiles are made safer, the argument is individuals are likely to be less careful while driving. Do they? Not all may engage in risk compensation. And those who do compensate may not do it all the time. So, safeguards are good, in general.

If safeguards are implemented to discourage retail investors from taking exposure to some risky investments, will these individuals look elsewhere to assume more risk? Taking more risk while driving a car may not always have an upside, if cars are made safer. But exposure to risky investments could pay off with higher return. So, it is possible individuals will look elsewhere to earn higher returns. Will this be the case given new norms with higher contract values and margin norms have made it difficult for retail investors to participate in the F&O segment? If so, is there an optimal way to moderate their behaviour?

Conclusion

One solution would be to offer retail investors an exposure to the F&O segment through mutual funds and exchange-traded funds (ETFs). While it may not stop all individuals from risk-compensating, it can at least provide an opportunity for such individuals to participate in the F&O segment through professional money managers.

This could include equity and commodity derivative strategies, combining futures, options and their underlying. At the extreme, stylised indices can be created to enable passive funds offer derivatives-based strategies. An example is a covered call strategy (long stock, short out-of-the-money call) through derivatives income ETF, a product that is popular in the U.S.

With appropriate regulatory changes, derivative funds can provide an opportunity to reduce direct retail exposure to the F&O segment while enabling the NSE to maintain price efficiency without substantial decline in trading volumes.

(The author offers training programmes for individuals to manage their personal investments)