Among the things that have emerged during the crisis that we’ve faced this year is a huge surge in retail accounts, with many used for day trading. People do need to be careful.
As good of a year that 2019 was for the stock market, we actually saw a decline in the amount of retail investing. In spite of the very nice gains we achieved with stocks last year, these gains were put in too modestly to attract much attention and this sort of trading environment just isn’t seen as all that exciting to many, especially with those who do not trade their own accounts and haven’t been tempted yet.
When the band is really playing loudly, like it did this year, the music can become loud enough that all sorts of new people hear it and start dancing to its beat. This year’s crash combined a lot of fireworks with a selloff so overdone made so much noise that even people that had very little clue of how stocks move became excited, causing the number of new brokerage accounts to explode.
The last time we saw such excitement was back in the late 1990’s, during the massive run-up in stocks, and tech stocks in particular, that had all sorts of folks fancying themselves as traders. All you had to do is jump on one of these stocks and ride it, and on the way up, everyone thinks that they are good, until they get bucked off the horse that is and end up eating dirt.
This is especially the case with those referred to as day traders, and day trading was red hot back in those days. It was so easy to trade back then, with so many wild horses to ride that ran like the wind, and all sorts of people were leaving their jobs and seeking success on this new frontier. Day trading became so popular that regulators had to place new restrictions on these day traders, similar to what they do with hedge fund investors.
Ever since, U.S. residents are required to maintain a minimum of $25,000 in their accounts at all times to be allowed to day trade on margin. This was done to ensure that traders have enough capital to take on the purported added risks of day trading, although regulators generally misunderstand risk in trading and instead prefer to go with old saws that just about everyone accepts without much thought.
Before we go into the resurgence of day trading that we’re seeing in 2020, we do need to go into what this style of trading is and what it is not, so we can at least gain a little perspective.
Day trading is what it sounds like, being in positions during the day with the intention of being out of them before the market closes. This in itself doesn’t make day trading riskier, it actually makes it much less risky. Day traders may even be horrified by the risk that investors take, or even other traders who actually hold a position overnight and subject themselves to what is called gap risk.
Those of us who remember the Apollo moon missions will remember that we would lose communication with the ship as it orbited the dark side of the moon, with their lines of sight being blocked by the moon itself, until it finally emerged on the other side.
Holding positions when the market is closed is like the dark side of the moon, where all sorts of things can happen to affect stock prices that aren’t manifest in the stocks until they emerge from the dark side the next morning, or even worse, on Monday morning after spending not just half a day on the dark side but two and a half days of darkness.
This isn’t a big deal if you are just investing, with no leverage, where you’re really not going to worry much more if at all about what may happen when the market is closed, or even what happens when it is open. Trading on margin magnifies both your advantage during the trading day as well as magnifying the risk when you can’t trade, and when the market is closed, you have no advantage but you certainly have the risk that is involved with this, all of it.
As well, the shorter duration your trades are, the more significant the duration of an overnight hold becomes. If you only hold positions for an hour on average, being stuck in a position for 17 ½ hours while your stock is on the dark side of the moon is simply out of proportion, not unlike walking away from a position like this for a few hours without checking or having any stop loss orders to protect you.
The biggest drawback of overnight positions for traders isn’t even the lack of being able to trade them actively during these off-hours, it’s the lack of the ability to manage these risks, where you are tossing your stocks in the air with the wind blowing in your favor, and then have to toss them up into the wind without much of an idea of how it will blow. It may even blow them into the storm drain and there’s no good way to protect yourself if you don’t have continuous action.
You may have paid $50 per share at four times leverage for a stock that you’re hoping to make a little gain from. Getting $51 would have you beaming, and as the trading for the day concludes, you see things pick up in your favor and it actually does get to $51. It’s still going up though so you might be thinking that you should hold on to it at least until the move starts to fail, a good decision normally.
Things don’t always go so well on the dark side and you see that your stock gaps down to $25 per share, which does happen from time to time. You not only have lost all of your money, you have lost twice as much as your original stake. This is what the regulators should be fearing if they had much of an idea of what goes on with this sort of trading, or trading in general for that matter. Where margin is concerned, if we are going to restrict it, we need to do so with those who actually do take on a lot of risk with it, not day traders but everyone other than day traders.
It is ludicrous to think that the exiting of trades before the close can be anything but much less risky than holding margin positions overnight when the risk of going bust or worse gets so magnified.
Day Trading is Very Misunderstood by Many
They look at how day traders do in comparison to investors, and while it is true that day traders fail at a much higher rate, meaning that they lose all of their money, it is not because they are not holding positions overnight. It is because the great majority of them don’t know enough about what they are doing, and trade badly, which would happen sooner if they actually did hold their stocks overnight and be swing traders for instance, holding for days to weeks.
This also blinds them to the reality of another crazy idea they hold, that somehow holding a position longer means less risk. The opposite is clearly true, and we can go back to our $50 trade to show why. Our trader is heading for the hills when his position is down by a percentage or two, if he or she knows anything about what they are doing, where people who hold longer need to accept bigger and often much bigger losses, otherwise they could not hold them as long as they do and would be out with the day traders down 2%.
2% is actually the high end of the risk that people should be taking in a trade, and this is after leverage, not before. If you are trading at the normal 4:1 margin, you can divide this by four and this means that if the price goes against you by just a half a percent, you’re out, by way of a stop loss order which sells your stock automatically if this level is breached.
Imagine holding on to a stock for very long when all it takes is a half percentage move to get you out. You have to give your trade a lot more room than this, otherwise you’ll just be trading like a day trader does whether you like it or not. Risk and longer holding times aren’t just correlated, they are fused together with an unbreakable bond. Shorter holding times equals less risk, not more.
We might then wonder how day trading could be a whole lot less risky but so many day traders fail. The simple answer is that if you are trading at a disadvantage, a higher frequency of trades and more leverage both multiply this disadvantage.
If you do not have a trading advantage, meaning that over time you stand to gain, you will eventually lose all of your money as this probability against you becomes more and more expressed. The best day traders, those with nice trading advantages, can achieve returns that would bend the mind of investors, especially those who trade futures contracts and use a lot more leverage than the more pedestrian 4:1 that you can get with stocks.
However, at a disadvantage, leverage is just going to beckon your demise all the more quickly, in this case, at four times the normal speed. It is also true though that trading with a higher frequency brings this on faster as well. If you lose 2% per 10 trades and only place 10 in your life, you’ll still come out with 98% of what you started with. If you place 10 trades a day, a whole lifetime of trades by this investor goes by every day, the damage caused by your lack of skill spirals out of control in no time.
You lose 2% in the first 10 trades, but your next 10 will lose 2% of the remainder, and so on until you are out of money. This is like a bad poker player asking to slow down time so they can play 1000 hands an hour instead of 10, and needless to say, they will surely be going home dead broke before too many hours pass.
This is a different kind of risk than regulators or non-expert traders speak about when they claim day trading is risky, but frequency risk is the real deal and is not to be trifled with. These are completely different concerns than holding positions overnight, what defines day trading itself, and having $25,000 or $2500 isn’t going to matter either way. If anything, these folks need to be making extra sure that they are flat at the close, because their challenge is great enough without adding to it this way.
Skilled traders turn this higher frequency to their advantage, where they gain a little on a balance of probabilities with each trade, which becomes multiplied by leverage. You either multiply your advantage or your disadvantage when leveraging, so you need to be careful you only multiply goodness and not just multiply badness.
You Have to Earn Your Chops to Be a Successful Trader
Just placing a few successful trades does not a trading advantage make, although you’d be hard pressed to tell this to a lot of traders who have become drunk by a few wins. There are plenty of folks who are beaming at making some simply fabulous returns from all the rebounding that has been happening to stocks lately, but just like the trading wizards of the late 1990’s where they made money from stocks going up a lot because that’s just what they did then, when the music stops, this can leave you sitting in a brand new world with no idea of what to do besides keep doing the same thing even when it doesn’t work anymore.
This is what happened to a whole lot of traders back then, and this happens to investors who choose their own stocks as well. When just about everything is going up, just about everyone can appear to themselves at least to be a genius, but when things slow down, their one idea that is completely out of harmony with reality will leave them helpless and ready to be fleeced.
Many of the massive number of newly minted day traders that were born out of the coronavirus pandemic may be basking in the sun now, but they need to be very aware that it rains out here too, and they need to be able to manage any weather.
These traders, hearing the sweet songs of how oversold some of the more distressed stocks may be, do need to be recognized by their insight in knowing when to enter these positions, but that’s only one of two skills needed to win this game, and the other one is even more important, which is knowing when to get out. This applies even more to those who are day trading because this is where they screw up, getting out at the wrong times.
The worst of entries should still only produce a small loss, as when it becomes clear that whatever you were looking to happen isn’t happening, it’s when we get out too soon on the way up and stay in too long on the way down that both robs our profits and loads on the losses. This is what we really need to focus on getting right if we wish to become traders who survive.
A lot of the huge increase in new traders these days are those who are both young and inexperienced, although the inexperienced part is not limited by age, as the experience that you need here needs to be gained by trading enough to learn enough.
You do not just inherit these skills as one would intelligence for example. There are no good maps, only some very vague ones that will require you to learn as you go, as you learn lessons that simply cannot be learned any other way. It’s not even easy to come up with anything that analogous to new traders thinking they have the bull by its horns, other than to say that if you do at this stage, it is surely a unicorn horn and you are definitely dreaming.
This is like being 10 years old and wrestling your little brother in a tag team match, and you don’t know that your brother’s partner is Mr. T. They tag and Mr. T stomps toward you calling you “fool,” and he is speaking the truth.
New traders have a couple of big advantages that previous traders could only dream about, which are fractional trading and commission-free trading. You don’t even have to buy a single share of anything anymore, and these fractions of a share are actually more liquid than a few shares used to be when anything less than an even lot of 100 shares was laughed at and considerably ignored by the market.
The battle cry against traders was always that the only people that they make rich are their brokers, and while this was true in many cases, now that we can trade commission-free, they don’t have that dog to kick around anymore.
Commissions are like the house edge in casino gambling, other than trading being a game of skill, and the bigger the advantage that the house has on you, the harder it is to win. If you just break even on your trades, you will lose the commission each way on them. You have to be good enough to beat the commissions, but if there aren’t any anymore, this opens up a whole new world and a bigger one than most people think.
Aside from saving the money you used to pay on commissions, this allows you to trade both any size and any advantage, where before you would need a significant amount of both. You can trade with just a few bucks and chase just a few cents of movement in a stock, high frequency trading on a shoestring.
This not only allows more people into the game, it also allows people to learn with the real thing without putting that much on the line. This was an advantage only offered with contract for difference and forex trades, and now it’s come to stocks.
You can now learn how to actually trade with real money instead of just a demo account, and the difference between trading with real and play money is immense. This is in many ways like someone who has only shot at targets getting into a real gunfight. The bullets may only be made of plastic with these smaller sized accounts, but you still feel them.
The only safe way to trade is to decide your account size and trading size based upon how well you have proved to be successful. A couple of good trades may bode well, but hasn’t really proven much. If you think this game is that easy, that you can just continue to do this, the time to stop is now.
Managed properly, learning to trade can be a rewarding experience provided that we insist on staying within ourselves and not pretending to be better than we actually are. It doesn’t matter much either way though as the error of our ways will quickly It’s just better to not have to learn the hard way though.