What Happens if the Government Raises Taxes on F&O Trading?

The debate on the trading of derivatives by retail investors is gaining momentum with every passing day. From hiking margin requirements to stringent net worth appraisals, the debate has now shifted to the imposition of a 30 per cent tax on derivatives transactions, similar to the taxation on cryptocurrencies.

All these rules are being framed to ensure that people do not take undue risks and for investor protection. They have brewed strong debates pertaining to the actual effectiveness and the broader impact they could have on market behaviour.

Understanding F&O Trading

The working of the futures and options (F&O) market needs to be understood before one delves into whether a 30 per cent tax measure would work. F&O are financial contracts used in trading.

A future is an obligation-treated agreement for the purchase or sale of an asset at a certain future date and at a certain price. On the other hand, options are rights, not obligations, to buy or sell an underlying asset at a set price before a particular date.

As for example, you believe the price of a stock is going to appreciate, then you will buy a call option to lock today’s price of that particular stock for future purchase. This tool is used by traders either to speculate for profit or hedge against a possible loss. As such, these tools are versatile in managing investment risks.

The Skill Versus Chance Debate in F&O Trading

How far is F&O trading actually based on speculation? If you believe that an event is going to affect the price of a stock, then you should have the necessary knowledge to judge in which direction the prices are going to move. Hence, it is a game of skills, not luck while trading F&O.

Say, for example, that you closely see the technology sector and think the earning report of one company would come out positive, beating market expectations and thus pushing up its stock price. You would be able to buy call options on the company’s stock strategically. It incorporates one’s ability in reading financial reports and market trends. In case the value of the stock rises, justifying your call options, you can reap huge profits from them.

Thus, F&O trading avails the market savvy, analysis, and Astute decision-making. This is a game of skill where astute predictions result in profit making rather than being left to chance.

Role of Hedging in F&O Trading

People trade in F&O nowadays due to hedging reasons. Hedging is an important strategy, as it safeguards the investment from market risks. Hedging of a cash position is done with options contracts that offset the probable loss of any particular position in F&O. Suppose you own some stocks of Rs 10,000 and may be you are afraid of downside in the market.

The put option can be bought to provide you with the right to sell your stocks at a certain price if ever their market value is depreciated. Therefore, with this strategy, the potential losses are limited, and you are open to upward rejuvenation of the market. You can think of hedging in F&O as assurance that will safeguard your investments from any sudden changes in the market.

The difference between hedging and speculation is that hedging reduces downside risk, unlike the latter, which looks to benefit from fluctuations in markets. It is hence a cautious approach to investments made in light of adverse eventualities. By restricting hedging, it will fuel volatility in markets because investors will be open to greater uncertainty and risk.

How Would a 30% Tax on F&O Trading Impact?

Such an imposition of 30 percent tax on F&O transactions will discourage hedging. After all,, distinguishing between speculation and hedging is virtually impossible. It will discourage investors from covering their positions in the best possible manner, which may result in increased volatility in markets and higher losses among the smaller investors.

Even if we dismiss these arguments and take the considered view that this 30 percent tax will actually restrict people from trading in derivatives, consider this: how many people are actually making money in F&O? The answer again, as per SEBI, comes that 9 out of 10 traders lose money in futures and options. If most traders in F&O are already suffering losses, a 30 percent tax on F&O trades may not deter new entrants or significantly reduce overall market participation.

The people who are already losing money may not be deterred because the tax itself does not affect those who suffer losses. Therefore, such a tax can have very limited utility in curbing the extent of speculative activity and reducing participation in markets.

On the other hand, some of the regulatory steps related to education, risk management, and transparency may help traders in the long term. Experts said this would take F&O trading out of the ‘business income’ to ‘speculative income’, which would not let investors set off losses from such trading against losses incurred in other business activities, like in the case of cryptos.

The move will tax income earned from the derivatives on par with lottery winnings or crypto investments, resulting in a flat 30% tax rate.

The introduction of TDS will allow the government to track investors in the F&O market. This provision was also introduced in Budget 2023-24 for cryptocurrencies as well.

Potential Consequences of Higher Taxes on F&O Trading

A higher tax rate on F&O trading could cast a deep impact on the retail investor and the broader market as well. For instance, if F&O trading income is considered as ‘speculative income’, the income tax rate would be a flat 30 percent plus 4 percent cess.

Since this won’t fall into slab rates of 5 percent, 20 percent and 30 percent on various income brackets, this could squeeze the margins of traders. This is because profits from F&O are allowed to be set off only against F&O losses.

Apart from this, increased taxation may not really dampen speculative activity because a large number of traders in the F&O market already lost money. Those who lose money can continue to trade despite the tax as the losses are not subjected to taxation. Therefore, the main impact of the tax could remain limited.

The Need to Educate and Manage the Risk

Some regulatory steps, oriented to education, risk management, and transparency, rather than depending solely on taxation, can go a long way in serving the better interests of traders in the longer run.

Investor education will certainly arm them with the ability to make discretionary decisions about the risks and complexities involved in F&O trading. Transparency in trading practices and tools for risk management can also reduce losses and safeguard retail investors to a large extent.