Legal and regulatory environment, accounting and taxation

Derivatives were illegal in India until 2000, and the framework that made them legal still decides what may trade, where, and on what terms. Sales staff who do not know it cannot tell a client why a stock left the F&O list or why their trading losses are not "speculative". This chapter covers the statutes, the eligibility rules, and the accounting and tax treatment at the level the exam tests.

The statutes

The Securities Contracts (Regulation) Act, 1956 (SCRA) governs trading in securities. A 1999 amendment, following the L.C. Gupta committee, added derivatives to the definition of "securities" in section 2 and inserted section 18A, under which a derivatives contract is legal and valid only if it is traded on a recognised stock exchange and settled through its clearing corporation, in accordance with the exchange's rules and bye-laws. The old section 20, which prohibited options in securities, was repealed. The effect: an exchange-traded derivative is enforceable; a private bet on Nifty between two individuals is a wagering contract and void.

The SEBI Act, 1992 created SEBI with the mandate to protect investors, develop the market and regulate it. Section 11 gives SEBI its powers, including the power to regulate exchanges, register intermediaries (section 12, under which every broker needs a certificate of registration), call for information, conduct inspections, and impose penalties (chapter VIA) adjudicated by its officers, with appeal to the Securities Appellate Tribunal. SEBI exercises these powers through regulations, such as the SEBI (Stock Brokers) Regulations, 1992 and the SEBI (Stock Exchanges and Clearing Corporations) Regulations, 2018, and through circulars that set margins, position limits and eligibility norms. Below SEBI sit the rules, bye-laws and regulations of each exchange and clearing corporation, which bind members and, through the member-client agreement, their clients. The J.R. Varma committee (1998) designed the risk containment measures, including SPAN-based margins, that the clearing corporations still use.

Derivatives trading began with index futures in June 2000, index options in June 2001, stock options in July 2001 and stock futures in November 2001. Currency futures came in 2008 under joint RBI-SEBI oversight and the current interest rate futures in 2014.

Which stocks and indices may have derivatives

SEBI sets eligibility criteria so that only liquid, hard-to-manipulate underlyings have contracts. For single stocks the current framework, revised in 2024 and applied as notified, requires the stock to be among the top 500 by average daily market capitalisation and traded value over the previous six months, to have a median quarter-sigma order size (the order value needed to move the price by a quarter of a standard deviation) above a notified threshold of ₹75 lakh, a market-wide position limit above a notified level of ₹1,500 crore, and a minimum average daily delivery value. A stock that fails the criteria for three consecutive months is dropped: no new contracts are introduced, but existing ones run to expiry. For indices, SEBI requires a minimum number of constituents and caps on the weight of the largest constituent and the top three combined, so that an index cannot be moved by trading one or two stocks; the specific numbers are as notified.

Accounting for futures and options

Two frameworks exist. Companies on Ind AS apply Ind AS 109: derivatives are financial instruments measured at fair value through profit or loss at every reporting date, so an open futures position is carried at its MTM value and the change goes straight to the income statement. Where the derivative hedges a recognised exposure and the entity documents the hedge, hedge accounting rules let the gain or loss be matched with the hedged item. Other entities follow the ICAI Guidance Note on accounting for equity index and equity stock futures and options, which is built on prudence:

• Initial margin paid is an asset, shown as "Initial margin, equity index futures account" under current assets, and released on squaring off.
• Daily MTM is accumulated in a "Mark-to-market margin, equity index futures account"; on expiry or square-off the net balance becomes profit or loss.
• At the balance sheet date, a net loss on open positions is provided for; a net gain is not recognised until realised.
• Option premium paid or received sits in an "equity index option premium account" until expiry, exercise or square-off; a provision is made at year end if the buyer's premium exceeds the current premium.

Brokerage, STT and charges on the trade are part of the cost for accounting but, for tax, STT on derivatives is a deductible expense of the business.

Taxation of F&O income

Income from trading derivatives on a recognised exchange is non-speculative business income. The Income-tax Act, 1961 excluded "eligible transactions" in derivatives from the definition of a speculative transaction in section 43(5), and the Income-tax Act, 2025, in force from 1 April 2026, carries the same treatment under its renumbered provisions. The consequences:

• Profit is taxed at the slab rate, with business expenses (brokerage, STT, data, internet, a share of rent) deductible.
• A loss can be set off against any other income in the year except salary, and carried forward for eight years against any business income, provided the return is filed on time.
• Contrast intraday equity trading, which is speculative: its loss can be set off only against speculative profit and carried forward for four years. A speculative loss cannot be set off against F&O profit, though an F&O loss can be set off against speculative profit.
• Securities transaction tax applies on the sale of futures, on the sale of options (on premium), and on exercise of options (on intrinsic value, paid by the buyer), at rates notified by the government.
• Stamp duty on the buyer, exchange transaction charges, SEBI turnover fees and GST on brokerage apply as notified.

Turnover decides whether a tax audit is needed. Under the ICAI guidance, turnover for futures is the sum of the absolute values of all profits and losses; for options it is the absolute profit or loss on each trade, with premium received on sale added only if it is not already included in that figure.

Turnover is far above net income because losses are added, not subtracted. Tax audit is required when turnover exceeds the limit notified for the year; since F&O settlement is entirely digital, the higher limit for businesses with almost no cash transactions normally applies. A trader may also opt for presumptive taxation on the turnover if eligible. Advance tax instalments apply to F&O income like any other business income, and losses must be reported in a timely filed return to be carried forward.