The Successful Day Trader

“Those who can, do,” a friend once told me; “those who can’t, write about it.” I thought it was insensitive to say the least — I was still at Harvard Business School, getting ready to take a job writing. But he went on to earn $40 million a few years later — his earnings for that single year, mind you — so I guess a certain arrogance was perhaps justified (and here I am writing about it, so I guess he was right).

This was brought to mind by a message from one of you — Jeff Schatz — who wrote in mid-April:

Am I nuts?

Ever since I discovered the amount of information, news, tips, etc. available online I’ve become a short term trading junkie — mostly momentum plays. I’m up over $53,000 since January and I’m waiting for the bubble to burst. In your experience is getting in and out of stocks quickly (1 day to 2 weeks) a valid investment approach?

[No! You get killed by transaction costs and taxes.]

I have about $250,000 in a high-yield moneymarket fund and $100,000 in four growth Mutual Funds w/Schwab that I use as margin or as trading capital.

My trades are typically 1000-5000 shares in stocks like Iomega (IOMG), America On Line (AMER), Cisco Systems (CSCO) and some smaller issues ($5 and under) like AMTX, AERN, etc. I’ve made 25 trades with a record of 18 winners, 4 losers and 3 breakevens. I look at charts and it seems possible to ride trends successfully.

I have access to real time quotes and use both a discount broker (Ceres $18 a trade) and Schwab (StreetSmart software, excellent service, quick fills, $66-150 per trade).

I use stop limits and follow trades very closely and can almost always “bail out.”

The answer I most wanted to give Jeff was, yes, you are nuts. In the long run, the odds are against you (because of the transaction costs and taxes). You’re not investing; you’re just playing trends which, in an amazing up market of the kind we’ve had from the time you started with this in January, has made anything seem possible.

But — smug — I figured I’d wait a few weeks and let him find out for himself.

A few weeks later I asked Jeff for an update, and on June 10 he wrote back:

I have continued my short-term trading activities and have been devoting more time to it, about 5 hours a day. My profits, since Feb. now stand at $190,000 or so, with commissions subtracted. My account at Ceres alone has grown from $20,000 to $68,000.

I now have Signal (an FM real-time quote feed), TickerWatcher (Mac charting and quote software). A lot of my information is gained online — Investors Business Daily and Wall Street Journal electronic editions and America On Line investment forums.

I’ve expanded my stock list to include lower-priced stocks and have been following the hot pennies, as well as my consistent winners like Iomega and America On Line. My strategy is to catch rising stocks — forget the top or bottom — ride them for a few points and get out. I set tight stop limits on the downside and try to let winners run, although I tend to be very fast on the trigger. I average over 3 trades a day and Ceres’ low commissions and web site are a godsend vs. Schwab, etc.

It’s very exciting and not as risky as I thought when I wrote to you — if you have the discipline to cut losers fast. I use 8% as my guideline on losses and 20% as a sell signal on gains.

I don’t worry too much about taxes. I’m already in the 30-40% range anyway. I view my gains just like salary.

If you have the fortitude, there appears to be a lot of money to be made.

Hmmm. It’s hard to argue with a $190,000 profit, even if it does take 5 hours a day to earn. So I guess the first thing to say is that some people do seem to have a knack for trading — for sensing the rhythm of the market, “reading the tape” and so forth. But clearly, over long periods this has to be a less-than-zero sum game. Unlike long-term investing, where everyone could theoretically come out ahead (from dividends and general growth in the economy), with quick trading, over the long-run, the odds will more than catch up to most people (though not all — Jeff may really have a knack for this).

The three most obvious pitfalls:

1. Transaction costs. It’s not just the commission, it’s the spread. Iomega sells for one price if you’re buying, an eighth or a quarter more if you’re selling.

2. Discontinuities. It’s fine to put in stop-loss orders designed to get you out of a position when you’ve lost 8%. But what if a stock gaps open down 30% as sometimes happens? Then you’ve lost more than you planned — and in case you’ve been juicing up your return with margin, more still.

3. A downtrend. What if they forget to sound the bell that signals the end of this bull market and the market as a whole drops 30% over the next year or two? If you know in advance that’s what it’s going to do, no problem — you can keep on making a fortune trading as you have been, only with puts or short sales. But it’s only easy (at least for me) to know these things with hindsight. So there’s the market “correcting” more than it’s rebounding — more bad days than good — and lots and lots of 8% losses with almost no 20% gains. So you switch to the short side, but now the market begins recovering, so you’re still racking up 8% losses before being stopped out of your short positions. (And on the short side you might even have occasional dividends to pay, although not, I expect, with stocks like Iomega.)

Having said all this, you should presumably keep on doing what you’re doing as long as it works for you. The only important suggestions I’d make, and I suspect you’re way ahead of me, are, first, to avoid margin and, second, to set, in your mind, an “overall stop loss.” That is, promise yourself you’ll quit this game altogether if you ever lose a third (say) of your accumulated peak profit. (And then keep that promise!) In other words, if you’re up $600,000 at some point, but that ever shrinks to $400,000, fold your tent. In this example, you’d get to keep $400,000 (before tax), save 5 hours a day, and avoid the possibility of losing the remaining $400,000 — and then some.

(Remember: if you make $600,000 this year and lose $600,000 next year,
you have not broken even, you’ve lost $230,000 or so. Why? Because in the 40% tax bracket you had to pay $240,000 in tax on the short-term gain, but get to deduct only $3,000 a year of the loss, which saves you only about $1,200 a year.)

Good luck! (And as you hit each new million, could I it you up for one of my charities?)

Tomorrow: The Other Side of This Story