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How to Really Make Money in Trading

The story of the man who started flat rate discount broking in India is an interesting pointer to how one can actually strike it rich in trading

It's an old saying that in a gold rush, the miners may or may not make money, but those who sell them the picks and shovels get rich. This is certainly true of parts of the stock markets, especially short-term trading by individuals.

The other day, while reading the story of Nitin Kamath, the man who has set up Zerodha, India's first and largest discount stock broker, I was stuck by the fact he is one of those who has gone over from being a gold digger to a seller of picks and shovels! As narrated by Kamath himself, he was trading on the markets since he was 17 years old. However, after receiving two big shocks on the markets, one during the dotcom crash and the second in 2009, he apparently decided to switch from digging to providing shovels to others.

There's more than a little irony in this story--a man loses big on the markets and decides to get out of trading and creates a business which will help others do the same. However, it perfectly encompasses the experience of practically a good proportion of individual traders on the Indian equity markets, the negative impact being specially amplified by the fact that their activity of choice is highly leveraged derivative trading. Typically, they make profits for short runs and then make large losses, all amplified by the leveraged nature of their trading.

In fact, it's interesting to see that there is a competition called 'The 60 day challenge' on the Zerodha website, which customers can participate in. All it takes to win this challenge is to not make a loss over 60 days! That's it. If you come out profitable (any profit at all) at the end of the 60 days, then you've done it--you've cracked the challenge. To the uninitiated like me, this appears to be an astonishingly low qualifying level for an activity whose only goal is supposed to be to earn money, but then I suppose that it must be rare enough to be an achievement.

As it happens, SEBI is reportedly trying to limit derivative trading among individual traders. A few days back, there was a report in this newspaper about SEBI planning to increase the contract size in futures and options trading on the stock exchanges. For the last 15 years, the contract size has been ₹2 lakh. Reportedly, SEBI now wants it increased to ₹10 lakh. The contract size governs the minimum ticket size that a futures or options (F&O) trade has to be. By increasing the contract size, SEBI would like to ensure that, only richer traders would trade in F&O segments.

And why would SEBI want to do that? Clearly, because an overwhelming number of individual trader are regularly losing their shirts in derivatives trading. As to the logic of trying to limit trading to those who can afford to trade with larger amounts, I'm sure it isn't because they are better at making money. Instead, it is the traditional idea that it's OK if richer people lose money on the markets but the small investor must be kept away from risky activities. Maybe there really is something to this line of thinking.

Obviously, brokers and stock exchanges are strongly opposed to what SEBI has proposed because it means lower revenue and profits for them although their official reasons talk about market liquidity etcetera.

Of course, derivatives (which are generally called effendo in India, which makes them sound like a magic spell from the Harry Potter books) have no inherent connection to discount broking. Discount brokers like Zerodha (and now others too) charge ₹20 per trade instead of the traditional percent brokerage. If someone is offering lower cost for the service, then that's fine. If the discounters are doing well, then traders must be finding their barebones services to be good value. It's the larger question of what role derivatives are playing in the Indian markets that's the real concern.