Is there anything more attractive than making a quick profit by picking smart stocks?
If you’ve had a lot of great deals, you might consider quitting your job to become a freelance day trader – perhaps even working part-time from home in shorts and T-shirts.
Day trading is exciting, and the rewards can seem alluring. But when you trade on a daily basis, you are flipping well-established principles of wealth building on its head. There are reasons why few day traders – independent or otherwise – do well enough to retire their trading profits.
Let’s take a look at the facts of day trading.
It is difficult to predict daily stock returns
Long-term investors do well because decades of market history will show that markets are predictable. If you follow certain rules, such as good diversification, keep costs low and stay fully invested in the stock market long enough, you will probably (but not guaranteed) make money.
The longer you allow the stock market to do its “magic”, the better your odds will be.
Once you look at a long enough history of daily stock returns, the odds of any stock going up or down on any given day are close to 50/50, which is like tossing a coin. The odds of being “right” on one throw are 50%.
But the odds of being right four times in a row drop to a little better than one in 16, or 6.25%. Yikes.
This risk can be multiplied by leverage. In their quest for higher profits, a trader can borrow multiples of his shares to take big trades.
For example, a trader who has $25,000 to invest can borrow $50,000 from his trading firm to keep a $75,000 portfolio. If the trader was right, the gain would be four times what it would have been without the borrowing. But when it’s wrong, that $25,000 takes four times the blow. This increased risk increases the probability that the account will reach zero.
It is true that stocks tend to rise more than fall, but the shorter the time you hold the stock, the more randomly it appears.
That’s why professionals call market returns as “a random walk with upward skew”. Do you want to photograph it? Imagine the path of a person with too much drinking trying to walk home.
We fool ourselves into seeing patterns that don’t exist
So you see a stock that traces a pattern that was working before. Does this mean the stock will behave the same way this time around? not necessarily.
We humans are smart, but sometimes – very often – we beat ourselves up by seeing patterns when what really happens is by chance, or isn’t as trustworthy as what we first think.
A stock that rose yesterday will not automatically rise again. It may stabilize or even reverse on its own (that’s that annoying random walk). Even the best performing stocks don’t go up straight.
Relying on patterns may lead to the worst case scenario of being “outcast”, when you enter at the wrong time, and then exit, only to see the stock reverse again.
It’s one of the mistakes beginners can make, but even professionals who use price patterns on charts sometimes get hurt. They protect themselves by investing only a small portion of their total investment portfolio in any one idea.
One of the most dangerous patterns we tend to follow is belief in our abilities.
We tend to overconfidence in our opinions and put too much risk in any one trade. A streak of winning trades can fool us into thinking we are incredibly talented at trading or even born under the right mark, when that streak of profit was just a dumb chance that, sooner or later, will reverse itself.
Day trading is expensive
Traders often spend fortunes on expensive computers and data services that help them analyze the markets. But this is just the beginning.
Other expenses related to day trading
Here are some of the other expenses that traders can get:
- Subscriptions to an endless list of newsletters.
- Seminars may or may not be useful, not to mention legitimate. Jugglers abound in search of day trade clients.
- Annual account fees and commissions. They are easily understood, and it is possible to shop for the best deals.
- Hidden costs such as margin rates or fees for borrowing stocks for a short sale.
Another hidden cost is the difference between the price you would pay to buy a stock and what you could get to sell it at the same moment, known as the bid-ask spread. If you are investing in stocks with little trading, this difference can build up the more you trade.
Long-term investors pay lower commissions per portfolio dollar, do not require the same amount of computing power and can get satisfactory results simply by applying easy-to-understand principles and being patient.
Who are successful day traders?
With millions of people investing in stocks, there are bound to be very few who are doing very well. Most of them are professionals who work for companies that can manage risks and discover opportunities much more quickly than those with individual brokerage accounts.
Equipped with quick access to market data, professionals can exploit even those intraday pips equal to fractions of a penny per share. But they have computing power, access to data, and data scientists, too.
Other traders may find a strategy that can work, but it is very rare for these “trading systems” to succeed in the long run because the markets are developing rapidly. These people are usually quick to deploy (start selling their great systems), but are also quick to perish (lose their customers a lot of money).
If you still want to try day trading
If you still want to trade after all these warnings, first try a simulated account where you don’t risk real money. Here’s how.
Skill Building Challenge #1
- Keep a journal writing why you bought the stock, why you sold it, and what you think went right or wrong.
- Try to invest only a small amount of simulation money in each idea.
- Then, and this is the tricky part, keep doing it both through the market trend up (which makes buying stocks look easy) and also when it is trending down.
After trying a simulated account, here’s the next day’s trading challenge:
Skill Building Challenge #2
- Have a friend print daily stock charts from the market’s great and awful times (like the Great Recession).
- Ask this friend to cover everything but the first hour of trading with a white paper.
- Then notice when you will buy and when you will sell as you gradually discover the chart of the day.
Do this a few times with the other graphs. Did you earn money? Do this a few times, again during different market periods.
If you still want to try day trading
Once you are confident enough to try investing real money:
- Only invest a small amount in any one trade.
- Don’t put too much of your money into one strategy that may cover many stocks that work the same way. This avoids heavy exposure to a single factor, such as technology or cheap stocks that are outperforming.
- Keep your trading account separate from your long-term investment account.
- Do not use leverage.
- Once you find a strategy that works for you, be ready to stick with it. Consistency will help you stay focused.
- Finally, compare your net results (after deducting expenses) with the industry standard.
Once you look hard enough at day trading, you’ll find that it has more in common with the Gold Rush of 1849: people made more money selling supplies to prospectors than prospectors made sifting through gold.
There will always be risks associated with investing. The surest path to successful investing remains to save money, invest in the long run, stay in the market and be patient.
Contributor Sam Levine is a Chartered Financial Analyst® and Chartered Market Technician® who has written on financial topics since 2003. He is an Assistant Professor of Finance at Wayne State University in Michigan.