Debate on Prohibition of Weekly Option Contracts in India

A significant debate in India centers around whether the state should leverage its coercive power to ban weekly option contracts due to concerns over retail participation and frequent losses among individual traders. However, such a prohibition could be a policy misstep and a misdiagnosis of the problem, potentially undermining financial-market development.

Framing the Debate Correctly

The debate is often incorrectly framed as a balance between speculation and investor protection. The appropriate perspective, grounded in financial economics, is whether India should progress toward more liquid and complete markets.

• Financial derivatives are key instruments for customizing risk, not merely speculative tools.
• According to Nobel laureates Kenneth Arrow and Gérard Debreu, an ideal "complete market" would allow perfect risk hedging through securities for every potential future state of the world.
• Short-dated options serve as practical instruments akin to one-period Arrow securities, isolating and trading the risk of single events on particular days.

Issues with a Ban

The Indian equity derivatives ecosystem is developing, but undue focus on protecting individual losses leads to flawed solutions. The prohibition could result from misdiagnosing problems like surveillance failures, exemplified by the Jane Street case.

• Banning short-dated options would reduce market completeness, efficiency, and liquidity.
• Prohibitive regulations punish the entire market for specific surveillance or decision-making failures.

Insights from Global Experience

An illustrative case is the CBOE's introduction of daily expiries on S&P 500 index options in May 2022, known as 0DTE options.

• By mid-2023, these options accounted for over 43% of S&P 500 options volumes, with a notional daily volume near $1 trillion.
• The growth did not lead to systemic instability but rather created a deep, liquid market ecosystem.
• The market consists of both retail clients (55%) and sophisticated institutional clients (45%).

Arguments Against a Ban

The rationale for a ban is seen as paternalistic, contradicting the economic liberty principle that consenting adults can freely enter into contracts without state prohibition, except for enforcing contracts and preventing fraud.

• Speculation is critical for liquidity, with speculators essential for hedgers’ trades.
• Banning derivatives could push risk transfer into less transparent, potentially illegal channels, increasing overall risk.

Policy Recommendations

Instead of prohibiting derivatives, policymakers should focus on building a comprehensive financial system.

• Encourage greater institutional participation in derivatives markets by removing state obstacles.
• Enhance market transparency through clearer risk disclosures and financial literacy initiatives.
• If expiry-day volatility is a concern, consider technical solutions like call auctions for closing prices.

Conclusion

Short-dated options are a successful component of derivatives markets, providing opportunities for building a sophisticated and resilient financial system rather than posing a threat.