Do Day Traders Make Money? (Part 1)
by Unknown Author
There have been a number of studies of day traders at specific firms that have attempted to answer the question of whether day traders make money. However, for several reasons, there is no definitive answer to the question. An initial problem is defining the term "day trader" and determining exactly how many day traders there are. Additionally most day traders do not publicly disclose their results. But we can piece together the various sources of information and come to some general conclusions.
Day traders were described in the preliminary prospectus for All-Tech (filed in 1998) as those who engage in the buying and selling of securities many times during the course of a day based on short-term price volatility. They typically close out open positions by the end of trading day in order to manage risk when the markets are closed. Positions are sometimes closed within minutes of the initial purchase or sale. Recent estimates of the number of dedicated "day traders" (that operate at day trading firms) are in the 5,000 range. Others estimate that there may be another 250,000 people that use some kind of software or dedicated systems to trade full time from home. These people should be differentiated from the more than 5 million people that have online accounts and that might occasionally place one or more day trades.
There have been many studies that have concluded that most day traders lose money, but there have also been studies that documented successful trading by day traders. The data currently available seems to imply the following results.
The majority of new day traders probably do lose money.
At some firms a very high percentage of day traders lose money.
However, there is some evidence that a majority of (surviving) day traders at some firms are profitable and many traders generate tremendous returns on their money.
Industry commentators also suggest that day-traders using software at home are much less successful than those trading at professional day trading firms. (See The Net Effect Of Day Trading from Inter@ctive Week (11/23/98))
Many investment industry veterans have suggested that day trading is a fad or and/or argue that it is based on faulty numbers. There have also been a number of studies and press articles that have concluded that the vast majority of day traders lose money. But some of these same people might be surprised to learn that there are also some legitimate studies suggesting that day traders do in fact make money buying and selling stocks intra-day.
Supporters of day trading can refer to a study that was published in the March/April 1998 edition of the respected Journal of Financial Economics. In "The Trading Profits of SOES Bandits" ( Abstract), Jeffrey H. Harris and Paul H. Schultz studied several weeks worth of data from two day trading firms and did indeed find evidence that the traders made money at the expense of market makers.
SOES bandits was the term used to describe individual investors who use Nasdaq’s Small Order Execution System (SOES) for day trading. 1000 shares was the maximum size allowed in SOES at the time of the study but SOES trading rules have changed since 1996, removing some of the day traders' advantages. Harris and Schultz studied data from two different firms and found that in aggregate, traders at both firms made money after commissions for the several weeks studied.
Harris and Schultz discussed the fact that SOES bandits were able to trade profitably with market makers even though they have less information. They suggest that because bandits keep the profits and bear the losses from their trades they have greater incentives to trade than the employees of market-making firms. The Bandits typically closed positions by placing limit orders through Instinet or SelectNet (a system that allows bids and offers to be sent electronically to all market makers in a stock). The principal advantage of SelectNet and Instinet to SOES bandits is that they allow trades within the Bid/Ask Spread.
Its important to note that theoretically, there is a simple reason why it is possible for market makers and traders to make money buying and selling stocks. In fact, many professionals (market makers and professional traders) consistently make money doing just that. See The Bid/Ask Spread and Market Makers for more on this topic.
The authors found that "SOES bandits make money only if they can close out positions within the spread through SelectNet or Instinet. Bandits who both initiate and close positions through SOES usually lose money." Interestingly, they found that trading profits declined when the holding period exceeded one minute and twenty seconds. Bandits lost money in positions held for more than five minutes.
This topic is also discussed in Saints or sinners? from CNNfn (9/1/99). According to the article "Finance professors are, in fact, divided about the viability of day trading" and Professor Schultz suggests it's a game best left to young people with good memories because the fast pace of trading.
On the other hand there have been a number of studies and investigations with less encouraging results. The most frequently cited is a study by Ronald L. Johnson for the NASAA. Johnson concluded in An Analysis of Public Day Trading at a Retail Day Trading Firm - Report of the Day Trading Project Group Findings and Recommendations (8/9/99) that the majority of traders studied lost money and the vast majority of traders ran the risk of losing their entire stakes.
In an administrative complaint filed last year against a now-defunct day-trading firm, Massachusetts securities regulators alleged that only one of the branch's 68 accounts made money. According to an article in the NYTimes (Do Diligence (RR) (8/1/99)) day trading has exceptionally high "washout rates" and "regulators who have examined the books of day-trading firms say that more than 9 out of 10 traders wind up losing money. Because most of these people disappear quietly when their cash runs out, few who replace them in the trading rooms know about them or their failures."
Gretchen Morgenson from the NY Times also discusses the topic with Harvey Houtkin in 2 Brokerage Firms Well Known in Frenzied Day-Trading World (RR) (7/30/99). Morgenson spotted the following statement on the All-Tech web site: "Electronic Day Trading attracts people dead-ended or unhappy in their current field of endeavor and people with a desire to make trading their life's work." According to Master of a New Universe from The Washington Post (5/16/99), Mr. Houtkin estimated that one in three people survive to become full-time day traders while one of All-Tech's regional managers estimated the figure to be more like one in ten.