Life of a Day Trader

On 06/24/2012, in Investment Strategies, by Jordan Wilson

Day trading in financial markets is not something I like to see in clients.

I prefer having clients take a long-term investing perspective, utilizing passive management strategies. Day trading – also known as stock flipping or high frequency trading –  is the polar opposite to this. Active management to the nth degree.

Successfully flipping stocks, bonds, and other asset classes is a tricky business. One that requires expertise, adequate time to research and continually monitor your portfolio, and  nerves of steel in volatile markets. A closet full of Milk of Magnesia might not hurt either.

That said, many individuals want to learn about day trading. A look at this topic today.

SmartMoney Magazine takes a look Inside the Life of a Stock Flipper. The article is well worth a read for those who wish to become day traders. And for those with no desire to flip assets, reading the article will reinforce your decision.

There Are Lots of Day Traders

As I said above, day trading is not my cup of tea (or vodka, tequila, et al). But many, many people do engage in stock flipping. And not just the Matt’s of the world.

In 2010, 70 percent of all purchases and sales of all stocks and bonds in the world were made by high-frequency-trading programs, called algo-bots. And that figure has increased since then.

As computing power increases and more complex software develops, high frequency trading may continue to rise. Even if you do not want to become a day trader, it is useful to read about how they operate.

It will also help you understand what is taking place when the next “flash crash” occurs.

Day Trading is Not Investing

High frequency traders are not investors. They are pure speculators. What do they do?

They gamble. When Matt decides to buy stock in a company, he has no interest in the price/earnings ratio, who the CEO is or what the sales figures are. He’s only going to own these shares for a few seconds before selling them, hopefully, for 5 or 20 cents more than he paid. All he cares about is how the stock price is moving.

If you want a career in speculating, consider becoming a day trader.

If you want to build wealth for a comfortable retirement, focus on being an investor.

Day Trading is Not Fundamental 

High frequency traders utilize technical analysis in their trading.

the simplest and most important day-trading move is “trend following”: If a stock is shooting up, buy some and ride it up until it falls. “Fading a move” is where you think a stock has ridden far enough up, so you bet against it by shorting it, hopefully predicting its downward movement.

Whereas fundamental analysis involves assessing the qualitative and quantitative “fundamentals” of a company (and its peers, benchmarks, etc.) to determine if it is a potentially good investment.

Technical analysts care little, if anything, about fundamentals. In fact,

At one point, Matt gestures at one of his lists of companies’ fluctuating stock prices: “I’m watching SINA, Sina Corp., which is — I don’t even know.”

Day Trading is Volatile

Given the speed of transactions, the high amount of competition (tons of individuals staring at the same software screens, rapidly punching buys and sells), the leverage being used, etc., day trading is a highly volatile activity.

At one point, in those minutes when the market was falling irrationally and Matt was buying, he was $90,000 down. “I get a little sick still, just thinking about it,” he says. He ran to the desk of Adrian Nico, the firm’s risk manager, and begged for more leverage, which Adrian gave him, allowing Matt to put $20 million of the company’s money into the market. “It seemed like it was the end of the world. No one was buying,” Matt says. “I feel really proud of what I did that day. I stepped in when no one was willing to.” He made $220,000. Another guy at the firm made more than $2 million. Another guy was at the dentist.

Volatility requires significant capital to handle the large value swings. If you want to day trade, have enough access to capital to handle down periods and cash calls on leveraged accounts.

Volatility requires constant monitoring. The greater your portfolio volatility, the more attention you must pay to your investments. If you have the time to constantly watch your assets, maybe you can become a day trader. If you work a regular job and cannot give enough focus to high frequency trading, think hard before giving it a try.

Volatility also requires strong nerve. With fundamental analysis, you can take some comfort that the underlying investment has upside potential due to its products, revenues, competitive advantage, management, and so on.  And with a relatively long investment period (relative being more than say 250 milliseconds), you anticipate that other investors will see the same things over time that you did, buy the asset and drive the price upwards. But with technical analysis alone, you need confidence in your software and your speed to identify anomalies and execute trades.

Day Trading is Risky

It is too bad that we only read about Matt’s story. And as Matt tells it.

Not to appear paranoid, but I have dealt with many “successful” investors in my life. Some have been truly successful over time. But many like to talk loudly about their success stories and not utter a peep on their losers.

And what about the other high frequency traders out there? While day trading is not necessarily a zero sum game, I do expect that when Matt prospers through his analytical tools, speed, experience, and nerve, his counterparty (who is less adept at flipping) may be losing on that transaction. Always remember, for every buyer there must be a seller.

It would be interesting to see the attrition rate for day traders. How many go bankrupt? How many break even but burn out? I suspect there are a lot of losers in the day trading business.

Even Matt Recognizes the Risk

Even Matt recognizes the risks involved in high frequency trading. I thought it was extremely interesting that:

Though he’s gambling his own money, it’s only about 20 percent of what he’s amassed; the rest is either in cash or in an indexed mutual fund.

A low risk and/or passive management approach for the bulk of Matt’s personal wealth? Sounds like a good idea to me.

And a strategy I do recommend for more aggressive clients who like some risk and excitement. Stick to a passively managed strategy of index funds for the vast majority of capital. But if you do want to take a more hands on approach (and have the time, skill, and experience), set aside (say) 10% of your capital to invest in individual non-diversified assets. Make sure you watch the leverage and do not raid the lower risk capital to finance losses though.

A good read with some positives to be found for those who want to become day traders As well as for those who do not.

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