Day Traders Will Have Fun Until They Get Wiped Out
(Bloomberg Opinion) - Once when I was sitting in my dorm, I heard a cry of joy from the hallway. My roommate announced that he had just traded $ 500,000 on the stock exchange after investing only a few thousand dollars. When I asked him how he did it, he grinned and just said, "Call options." I spent the rest of the day reading about how this wonderful financial instrument can be used to make a fortune on a day with just a small start.
Of course, my lucky roommate doubled his investment and ended up losing most of his money when the dotcom bubble burst a few months later.
This saga shows the danger of day trading, especially with leveraged instruments like options. Daily trading declined after the tech bankruptcy in 2000, but the coronavirus pandemic appears to be driving a renaissance. Goldman Sachs Investment Research reports that the percentage of trading in the stock and options markets from small businesses has increased significantly since January, while discount broker TD Ameritrade reports that visits to its website have made people trading stocks teach, have almost quadrupled. Robinhood, a trading app that offers commission-free commissions and a simple video game-style interface, opened 3 million new accounts in the first quarter. Half of the new customers are first-time investors. Many online communities are filled with the standard elements of day trader culture - stories about fabulous assets, hot tips, trading systems and theories and so on.
Corona virus is probably not the only reason for the day-to-day boom. The brokers realized that they could offer commissions without commission and offset this with interest earned from borrowing their cash balances. Mobile apps made trading easier and more entertaining than ever, and allowed new traders to start with small amounts of money. A new generation of speculators has no painful memory of the Dotcom bust.
Whatever the reason, the new day trading craze is unlikely to produce a happier result than the last one. There are many theoretical reasons and a wealth of empirical evidence that most day traders waste their money.
One of the most important concepts in finance - and yet apparently one of the hardest to understand - is that every trade has two sides. For a day trader to make money, someone else has to lose money. In the most optimistic case, the loser could be a normal person who has to deposit or withdraw money from their retirement account and is therefore not worried about the price at which they buy or sell. But most trades are not. Instead, day traders typically buy and sell either from each other or from algorithms programmed by experienced finance professionals. If it is the former, their trade is a zero-sum game. If it is the latter, human day traders are very likely to lose because the people who program trading algorithms are usually very smart and their computers can recognize market-changing developments faster than people. For this reason, professional traffickers have been increasingly pushed out of the market.
A related problem is the idea of hatching. Day traders might think their trades are free because they don't pay commission. However, when a daytrader places an order, a trading algorithm quickly determines somewhere that he wants to buy or sell, and increases or decreases the price accordingly, so that the daytrader receives a less favorable price.
Another reason why day trading is a bad idea is that people often don't understand when to win and lose. If the market as a whole rises (as of late), many stocks will be winners. This can make a day trader feel like he has won, even if he would have made as much or more money if he had simply bought an index fund and held on to it. This is especially true now when the correlations between stocks are very high - in this case it means that many stocks go up or down together.
After all, day traders often don't understand how much risk they take. Call options, such as my college roommate bought, are leverage - you can make fabulous riches, but you are very likely to lose your money. A young newcomer tragically committed suicide after seeing that his account was causing huge losses. Although he probably misunderstood the bank statement, this incident means that investors may not be prepared for how much money they can lose from the trades they make.
A large number of empirical evidence confirms that most day traders lose money. For example, a very large 2004 study on Taiwanese day traders found that more than 80% lost money. A tiny number - around 0.03% - made consistently high profits, but the chances of having this type of skill are slim. Most studies by day traders in the US and Finland give similar results - some traders are consistently good, but most lose.
Day-to-day business could therefore be a fun way to gamble for those who are locked inside and waiting for the pandemic. But when regular Americans start putting large amounts of their money on individual stocks and options, they seek financial ruin. If you want to trade daily, it's best to just wager a small percentage of your money to find out if you're one of the few who have the ability to beat the market. Daily business should be treated like an expensive video game, not a way to get rich quickly.
This column does not necessarily reflect the opinion of the editors or Bloomberg LP and its owners.
Noah Smith is a columnist in the Bloomberg Opinion. He was an assistant professor of finance at Stony Brook University and blogs at Noahpinion.
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