The case for day-trading: there isn’t much of one

A story about two day traders in California

The Sunday New York Times, which features human interest stories more than “hard” news, ran a story that recounts “a day in the life” of two day traders in California last weekend.  They support themselves by trading for their own accounts using technical indicators.

The more successful of the two says he has earned $100,000-$120,000 a year from his trading business over more than a decade.  He and his partner also give lessons to others, as well as trading for themselves.  They charge $199 a month and on the day the NYT followed them around they had at least 21 subscribers.  If those students all stuck around for a year, the trading “school” would generate income of about $50,000.  It’s not clear whether these fees are included in trading income.

When asked about how they operate, the two traders are “momentarily stumped” and “struggle to put a finger on what set-ups (i.e., favorable trading opportunities) are or how to spot them.”

Trading results on the day in question?  –60,000 shares traded, $300 in commissions, a loss of $135.

Academic studies:  active traders have worse results than their less active peers

in the US

The article then cites an academic study of US discount brokerage clients that seems to verify what professional investors in the US fervently believe, that the more you trade, the worse your results are.  Trading is emotionally satisfying but deadly to your bank account.

and in Taiwan

To me, however, the most interesting part of the article is its reference to an as-yet unpublished academic study of frequent traders in Taiwan (earlier versions of the paper can be found online ).   Why Taiwan?  — day trading data there are publicly available.  The research finds that a small core of individual day traders consistently makes money, but 99% of day traders make losses. Related research by the same authors shows that in Taiwan foreign institutions are the most profitable traders, followed by other institutions, ex corporations–which lose money after transaction costs.  Individuals as a class lose money, even before costs.

I don’t think Taiwan is a microcosm for the world as a whole.  My experience with this country is that individuals’ investment preferences and the universe of possible investments are far different from those in, say, the US.  Two things strike me, however.  The number of stocks available on the Taiwan Stock Exchange is relatively small vs. the US, suggesting that American day traders face a more daunting task than those in Taiwan.  Also, I wonder why corporations are consistent trading losers in Taiwan.  If their activity were relationship investing, one wouldn’t expect a lot of trading.  Since other trading in Taiwan seems to be symmetrical–foreigners win, locals lose; institutions win, individuals lose–could there be a symmetry between the small cadre of winning day traders and the loss-making behavior of corporations?  Hmm.  What would that mean?

Why I think day trading makes so little money

1.  I’m a fundamental analyst.  That is, I think that stock prices are ultimately determined by economic events in the real world.

At times and in places were there’s a paucity of fundamental information (think: emerging markets) or where the investing culture is heavily involved with charts (thing: Asia), technical analysis is very important.   If a company doesn’t talk to investors, or if the macroeconomic data have to conform to an official government plan instead of reality, or if syndicates of insiders can make stocks go up and down as they please (as was the case in the US in the Thirties) then it’s hard to formulate an investment strategy based on anticipating how the economy will play out.

That’s not the case in the US today, however.

The biggest problem I see is that investors can be overwhelmed by the huge amount of data that gets dumped into the market every day–government statistics, academic studies, company announcements, analyst reports, news articles.  It’s hard to judge what data are relevant, as well as to sort through the sheer volume to get to the valuable stuff.

So a strategy that tries to “read” the conclusions of other investors through chart action puts you behind the curve.

I don’t mean that people shouldn’t use charts.  I do believe that the prices talk.  It’s just that they’re confirming signals for what you’ve puzzled out elsewhere, or early warnings signs that others don’t believe the rosy picture you’ve painted for a given stock.

2.  derivatives muddy the waters.   In the heyday of technical analysis in the US, there were only stocks.  Then there was a time when the same people dealt in both derivatives and the cash market, so the picture they presented in their trading might have been more complex, but it was a coherent whole.  Now, however, we have three classes of investors:  investors in stocks and bonds only, investors holding physical securities plus derivatives, and investors holding derivatives only.  Intentions, goals, and benchmarks among the three classes may be quite different.  So the signals that the trading of the three groups give may not form a coherent whole.  Each world is capable of sending apparently senseless ripples into the others, however.  A derivatives-only investor makes a transaction.  His brokerage house counterparty then hedges part or all of his position by buying/selling in the physical market.

Another simple example:  Years ago, there was a close correlation between the pre-market price of stock index futures in the US and the opening level of market trading.  No longer.  Watch for a week or two if you don’t think this is right.

All I’m saying is that it’s much harder than it used to be to read what the market is thinking.

3.  colocation. For many years, market quants have been automating/computerizing various technical rules so that they can execute trades more rapidly.  Over the past several years, there’s been a movement of these investors to “colocation,”  that is, to position their trading computers in the same building as, and as close as physically possible to, the location where the computers of market makers or exchanges execute their transactions.  Why?  –to avoid the infinitesimal delay that would result from sending an electronic impulse down a fiber optic cable from, say, 20 miles away.  Playing with these guys is like sword-fighting with Zorro (or arm-wrestling with Superman, or…).

4.  commissions/spreads. Let’s say the daily commission total of $300 mentioned for the day trader in the NYT story is an average outlay for him.  That means he spends about $75,000 on commissions in a year.  Does this make him an important customer of a brokerage house?  Yes and no.  Yes, the broker would prefer to have the $75,000 rather than not.  But even investment firms outside the top twenty in the US are capable of generating $75 million in yearly commissions.

Brokers also make money on the bid-asked spreads they charge.  There’s every reason for a broker to offer narrower spreads to the $75 million customer (who will have a professional trader in constant contact with a number of brokers, and who will ask), none at all to offer them to the $75,000 customer.

In other words, the small day trader has a constant cost disadvantage against large professional firms.  Trades that may be highly profitable for a colocated quant who can identify narrow spreads and negotiate low commissions can easily be money-losers for the day trader.

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