Second Order Effects

SEBI increases F&O contract size to 15 lacs

Every action has a consequence, and each consequence has another consequence. This is called the second order effect.

Generally speaking (exceptions are always there), when a group of people with pedigree (typical degrees and experience) sit together to make decisions, they invariably end up arguing (based on their incentives and pressure from above) their exact specific point. The final decision is always the common minimum benchmark to which all the parties agree (or atleast not disagree)

Problem with such a decision is that it caters to only the first order effects of the outcome. It completely discards the second and God forbid the third order effects of that decision.

Something similar has manifested in SEBI decision to increase the margin for trading derivatives (from 5 lakhs to 15 lakhs).

Disclaimer: This is my limited opinion, based on my limited understanding of trader’s psychology so take it with more than a pinch of salt.

Here is my point.

This is functional equivalent of increasing the cost of cigarette hoping that it will act as a deterrent.

I do not know many (any) smoker who left smoking just because his brand of cigarette doubled or even tripled in price. Now you may argue that may be my sample size is skewed as I know only middle/upper middle class people.

Fair enough: but point is, even with lower middle class or poor set, increase in prices won’t stop them from smoking, it will just lead to change of brand or product.

The second order effect of this decision is that the percentage of successful traders will go down further. One of the biggest reasons why Retail fail is that they are under-capitalized (over leveraged). Loss from a single excursion (trade) should not be more than 0.2 to 1% of your portfolio allowing you enough trades for the edge to play its magic out. With increase in lot size, an already under capitalized retail will become a degenerate gambler (if he was not already) and a single losing trade will have substantial impact on his portfolio. 5 such trades on a streak and he is OUT.

Third order effect is the shift towards casino and dabba trading. In a capitalist market, somebody’s loss is somebody’s gain. You cannot save retail. Warren Buffett said it the best, “A fool and his money are soon invited everywhere”.

He will find newer and newer ways to part ways with it.

It is not Regulator’s job to protect retail, (apparently, it is, in a socialist country). Their job is to ensure a level playing field. This, infact sets a wrong precedent, When you allow government (regulator) to protect you, You or even they won’t know where the line is.