Day Trading

views updated May 11 2018

Day Trading

The Securities and Exchange Commission (SEC) defines day trading as follows: "Day traders rapidly buy and sell stocks throughout the day in the hope that their stocks will continue climbing or falling in value for the seconds to minutes they own the stock, allowing them to lock in quick profits. Day trading is extremely risky and can result in substantial financial losses in a very short period of time."

In its investigation of the practice, which arose in its most modern form with the Internet, the U.S. Senate Permanent Subcommittee on Investigations defined day trading as "placing multiple buy and sell orders for securities and holding positions for a very short period of time, usually minutes or a few hours, but rarely longer than a day. Day traders seek profits in small increments from momentary fluctuations in stock prices after paying commissions." In the more technical language of the National Association of Securities Dealers (NASD), day trading is "an overall trading strategy characterized by the regular transmission by a customer of intra-day orders to effect both purchase and sale transactions in the same security or securities."

Canada and the World magazine, in an article titled "Rolling the dice," saw analogies to day trading in the "bucket shops" of the 1920s. "They were storefront businesses where traders gathered to buy and sell stocks. Many were illegal and not unlike off-track bettering shops. Customers were doing no more than placing a bet on whether certain stocks would rise or fall. In the Roaring Twenties, just about everyone could score in a bucket shop. Buy your stock, any stock, in the morning; by evening you could be confident you could sell it at a profit." Most of the bucket shops, according to the magazine, disappeared in the stock market crash of 1929—only to resurface as Internet-based day trading programs in the bull market of the 1990s. As air rushed out of that bubble, day trading almost collapsed. With the market strengthening again in the mid-2000s, market analysts, here and there, see day trading reviving again.

DAY TRADING AS GAMBLING

Ever since the emergence of stock and currency markets in the 16th and 17th centuries in Europe, an element of chance has been a strong component of trading in stock so that, around the world's stock exchanges, the movement of stock prices, up and down, has become the main focus of traders' attention and the original (and still central) goal of selling stock—namely raising capital for a business—is mentioned only in the context of "prudent" investing for the "long term."

As Larry Williams pointed out in an article on day trading in Futures, today's markets still behave as they always have. What has changed, above all, is volatility and speed. "Virtually every day-trading system offered for sale for the last 30 years," Williams wrote, "hasnot been a hard and tight mechanical system…. So, if you what you want is a fail-safe purely mechanical system, I'd suggest you turn your attention to real estate investing or bank accounts." [Emphasis added.]

Day trading differs radically from "prudent investment" in that it is based on very brief movements in the price of stocks. These movements are exploited (or attempted to be exploited) in the most modern form of day trading by using very rapid communications techniques provided by the Internet. Stock is not held for any length of time at all. The transactions are based on watching one or many trend lines conveyed to the trader's screen electronically. Buying and selling is based on a pattern of change. Actual information about the company whose stock is bought or sold is therefore less important than any kind of rumor, be it true or false, which will change that pattern for a few minutes or hours. For these very reasons, day trading is more akin to gambling than investment. Not surprisingly, promoters of day trading and those claiming expertise in it emphasize techniques of trading all of which have the flavor of "systems" used in gambling, e.g., counting cards or statistically evaluating the frequency of black or red on the roulette wheel—and knowing when to hold or fold.

WINNERS AND LOSERS

Statistical data on the performance of day traders are largely anecdotal, but the conclusion is that most people lose money, some in a spectacular way. Canada and the World magazine cited one such spectacular case, that of Mark Barton. "He lost hundreds of thousands of dollars day trading in an Atlanta branch of the All-Tech Investment Group. Shortly after that, in July 1999, he walked into the All-Tech offices and shot and killed nine people."

One comprehensive study of day trading was conducted by four scholars (Brad Barber, Yi-Tsung Lee, Yu-Jane Liu, and Terrance Odean) focusing on the Taiwanese stock exchange. They studied 130,000 day traders over a five-year period, 1995 to 1999. Barber et. al. discovered that most day trading is done by a few. "About one percent of individual investors account for half of day trading and one forth of total trading by individual investors." Do these heavy traders make a lot of money? The authors go on: "Heavy day traders earn gross profits, but their profits are not sufficient to cover transaction costs. Moreover, in the typical six month period, more than eight out of ten [actually 82 percent] of day traders lose money." Only a tiny handful, according to the authors, made a strong return. It is worth noting that the period of the authors' study coincided with an expanding market.

ELECTRONIC DAY TRADING

Day trading in its current form has its origins in the birth of the computerized, over-the-counter NASD, which occurred in 1971. Fourteen years later, NASD created the Small-Order Execution System (SOES). SOES made it easy for individuals to execute stock trades automatically so long as the orders were for 1,000 shares or less. Trades placed through SOES bypassed the phone lines used to make most trades and placed orders in a matter of seconds, instead of minutes. While SOES users may not buy or sell the same stock during a five-minute period, there were still a group of daring investors who thought they could use SOES to make rapid stock transactions to make a great deal of money. Thus day trading was born.

The modern day trader is no longer limited to SOES. Indeed, the most popular tool for the day trader today is electronic communication networks, or ECNs; they are internal networks set up to handle groups of customers who make large blocks of stock trades. All the members of one ECN may trade directly with other members of their network, placing buy or sell orders electronically. This has become the main tool of the day trader. To best use that tool, day traders watch the NASDAQ Level II screen religiously on their computers. The best bid on any given stock is displayed on the NASDAQ Level I screen, while the Level II screen displays all bid prices for a selected stock. This increased amount of information allows the trader better to gauge what is happening with the stock: What are the high and low bids? How many bids have been made? Are the number of bids increasing or decreasing? This information is invaluable as the day trader decides which stock to buy.

With the growth of any money-making activity come the hangers-on—true for day trading as well. Book and newsletter publishers, authors, commentators, and consultant stand ready to share their wisdom with the would-be day trader. Anyone tempted to participate in this activity might, however, begin by carefully reading what the SEC see has to say on the subject at its Web site, http://www.sec.gov/answers/daytrading.htm.

BIBLIOGRAPHY

Anuff, Joey, and Gary Wolf. Dumb Money: Adventures of a Day Trader. Random, 2000.

Barber, Brad and Yi-Tsung Lee, Yu-Jane Liu, and Terrance Odean. "Do Individual Day Traders Make Money? Evidence from Taiwan." Social Science Research Network. Available from http://papers.ssrn.com/sol3/papers.cfm?abstractid=529063. January 2005.

Barker, Robert. "Day Trading: It's Not Always A Fool's Game." Business Week. 16 August 2005.

Bresiger, Gregory. "The Return of The Day Trader: But Is Another Disaster Around the Corner?" Traders. 1 February 2004.

Catton, Grant. "NASD Seen Moving Toward Limiting Day Trading." Compliance Reporter. 31 May 2004.

"Credit Extension/Day Trading Requirements." Notice to Members. National Association of Security Dealers (NASD). May 2004.

D'Souza, Patricia. "Day Trader's Blues." Canadian Business. 16 October 2000.

Kitchens, Susan and Michael K. Ozanian. "Last Man Standing." Forbes. 23 May 2005.

Maiello, Michael. "Day Trading Eldorado." Forbes. 12 June 2000.

McGinn, Daniel. "Do-It-Yourself Isn't Dead Yet: Day trading was all the rage during the bull run. But even with stocks falling, many are still at it, and adding new recruits. Just don't call them 'day traders' now." Newsweek. 3 February 2003.

"Rolling the dice." Canada and the World Backgrounder. May 2003.

Schwartz, Nelson D. "Meet The New Market Makers: They're Young, They're Rich, and They Couldn't Care Less about Graham & Dodd. But They're the Ones Driving Those Insane Tech Stocks, and They're Not Going Away." Fortune. 21 February 2000.

U.S. Securities and Exchange Commission. "Day Trading." Available from http://www.sec.gov/answers/daytrading.htm. January 2005.

U.S. Securities and Exchange Commission. "Day Trading: Your Dollars at Risk." Available from http://www.sec.gov/answers/daytrading.htm. 20 April 2005.

U.S. Senate Permanent Subcommittee on Investigations. "Day Trading: Everyone Gambles but the House." 24 February 2000.

Williams, Larry. "Day-Trading modern markets." Futures. 15 September 2001.

Darnay, ECDI

Encyclopedia of Small Business

Day Trading

views updated Jun 11 2018

DAY TRADING

As one of the new economy's most popular pastimes, day trading generated intense emotions from supporters and detractors alike, and the practice was the source of much controversy. Sometimes referred to with derision as "recreational trading," day trading is a form of stock market activity in which investors, known as day traders, make blitzkrieg runs on several stocks for the purpose of generating very quick gains, but without an eye toward long-term returns. The logic behind day trading holds that the rapid buying and selling of securities in response to very incremental movements can generate quick profits that result in tremendous savings over time.

The practice is premised on the idea of that markets aren't completely efficient. Therefore, small profits can be made by trading in expectation of tiny, incremental movements in stock. Day traders move in to capitalize on the market's corrections. Repeated often enough, these small transactions can escalate into hefty profits by the end of a day's trading, at which point day traders generally liquidate their entire portfolios. Since companies may issue announcements and company news after a day's trading has closed, day traders don't generally want to hold onto stocks overnight, since their line of work entails making split-second buy and sell orders before others can beat them to it.

Day trading requires a nose for minute stock movements, keen trend-spotting skills, and a ready mouse-click. However, professional day traders also rely on tools like sophisticated analysis software and charting programs and a steady stream of financial news. Many online financial portals and content sites feature real-time stock quotes, and some provide charting and chart-customization services. Some electronic trading systems are capable of performing what are known as basket trades, in which several hundred securities are bought and sold in a single transaction. These systems were tailor-made for the day-trading world, in which traders frequently buy and sell thousands of stocks in a single day, and were particularly useful for the big, end-of-the-day liquidations.

DAY TRADING'S ROLLER-COASTER RIDE

Day trading, in its present form, got its start in the early 1990s, according to Institutional Investor, when a New Yorker named Harvey Houtkin began monitoring the delays between breaking news events and the adjustment of prices by certain dealers. Using the Nasdaq's Small Order Execution System, Houtkin made a name for himself by exploiting those delays to make a profit. By doing so, he opened the flood-gates to hordes of new independent traders making connections to exchanges. In addition, these activities engendered the momentum that would evolve into the e-brokerage boom and the emergence of new trading media like electronic communications networks (ECNs).

Day trading made a splash in the late 1990s as the U.S. bull market seemed to defy gravity and news accounts lauded the new economy. Additionally, the Internet opened new lines of business and gave birth to the dot-com stock craze while also lowering the costs of trading. All of these factors enticed new entrants into the field of stock trading. In order to compete with the traditional Nasdaq market makers without paying hefty, profit-reducing fees, day traders began to create their own electronic trading networks, such as Island ECN, to provide a space for buyers and sellers to trade and share real-time market information. As day trading grew more mainstream, the major online trading houses increasingly assumed the capabilities of the larger brokerages. They developed the technological means to simultaneously scan several securities markets, locate the best prices on given securities, and then purchase them instantaneously.

The day-trading binge was cradled by the can't-miss buzz surrounding dot-com stocks in the late 1990s. Paradoxically, this was a buzz that day trading helped to sustain. The most sensational stories told of middle-level office workers making millions by trading on their lunch breaks, or quitting their jobs to trade full time and retire at age 30.

In all, however, the hype surrounding day trading tended to inflate individuals' expectations, often to drastic effects. While there was, indeed, no shortage of success stories, they were in fact an unrepresentative sample. The North American Securities Administrators Association (NASAA) reported in 1999 that 77 percent of all day traders wound up losing money, while the average profit of the winners was a mere $22,000 over a period of eight months. This was a far cry from the instant-success stories in which mechanics were able to retire after a few months' trading. The dizziness of the cultural phenomenon reached its most harrowing moment in July 1999, when a distraught day trader, having lost some $100,000, murdered his wife and children before wandering into two Atlanta day-trading offices—at which he had placed orders—with a gun, killing nine workers and himself. This horrifying event greatly exacerbated the growing backlash against day trading.

Day trading emerged as a fear among employers as well. With more and more workers secluded in offices or cubicles with their own computers and Internet access, the temptation to engage in day trading on company time was a source of growing concern. To stave off such slacking, companies resorted to installing Universal Resource Locator (URL)-filtering software on company machines, designed to lock employees out of selected sites or domain names.

Day trading eventually became nearly synonymous with the high-stakes excesses of the glorified bull market, while emerging as one of the primary forces driving the market's wild volatility in the late 1990s and early 2000s. On the other hand, it also was indicative of the wider democratization of the once exclusive world of Wall Street trading, and enhanced the market populism that became such a central part of U.S. culture in this period. In 2000, the NASAA reported that a whopping 7.5 million Americans maintained 7.5 million online brokerage accounts, while the Electronic Traders Association estimated between 5,000 and 10,000 investors placed orders through specialty day-trading houses.

Following the dot-com and tech-market bust in spring 2000, day trading was widely seen as a passing fad, and in large part the novelty was just that. But day trading never went away completely and by 2001 the practice was not only still alive but, by some estimates, healthier than ever, according to Fortune. While the field underwent a shakeout similar to that of the dot-com economy, meaning that the casual part-timers were largely forced out of the field, the ranks of professional day traders stabilized at about 50,000 nationwide. Bear Stearns reported that, while the market registered a 37-percent decline in 2000 in the volume of trading by occasional day traders—those making 15 to 40 transactions annually—day trading as a whole increased its volume by 55 percent.

As of 2001, the future of some major online brokerages looked murky. This especially was true for those firms, such as Ameritrade and E*Trade, for which occasional trading constituted the cornerstone of their business. Such firms poured vast sums into marketing in the early 2000s in efforts to maintain the footholds they'd acquired, and were likewise seeking to branch out in order to stay afloat, diversifying away from an increasingly risky market.

Day trading washed up on European shores several years after it dominated American business headlines. However, with it came the lessons of the American phenomenon. As a result, day trading was expected to take hold more slowly and more subtly than it had in the United States.

THE IMPACT OF DAY TRADING

Day trading brought mounds of new money into the market. Moreover, this was money managed not by the traditional blue-chip investors or fund managers, but those looking to enter and exit a market quickly with only a short-term gain in mind. As a result, day trading was largely responsible for the wild dayto-day fluctuations in stock markets, particularly the Nasdaq, in the late 1990s and early 2000s. In effect, day trading altered the traditional theories about how markets work by dramatically boosting the degree of market volatility and transforming perceptions of risk exposure.

Among professional money managers, day trading was widely perceived as a form of gambling engaged in by uninformed amateurs. Still, this didn't always lead to calls for the abandonment of the practice. Gregory J. Millman, writing in the investment journal Barron's, compared day traders to a swarm of maggots, insisting that, while they may be loathsome, day traders do a good job of eating away at the market's "diseased tissue," those "inefficiencies that slow and sicken markets."

Such statements, though harboring much of the animosity still felt by traditional investment analysts, nevertheless reflect the general sentiment prevailing in the early 2000s that day-trading's existence was more or less accepted. Whatever one's feelings about the practice, day trading grew into such a force that, by the 2000s, investors of all stripes had little choice but to take day trading seriously, as its effects couldn't be denied. More positively, it was a growing source of income.