Hi OZ; I wrote this for a relative, but thought the intro to daytrading might be of general interest:
WHAT IS DAYTRADING?
First of all, I am going to here define "daytrader" as someone who is
directly connected into the Nasdaq computers, and pretty much trades
all day, every day. There are a lot of people who are trading all day
using connections on the internet. They are not directly connected to
the Nasdaq computers. Consequently, their orders go through a broker
like Charles Schwab, or even E-Group. There are hundreds of thousands
of people playing the market using internet orders, but there is only a
very small number of daytraders. I've seen figures of around 5,000.
From watching the market action on stocks, I suspec that this is about
the right number. My guess is that those daytraders are equally split
between those who trade in an office and those who trade from their
homes, though this is a complete guess. The vast majority of people
who trade from their homes are not connected to the Nasdaq direcly,
and therefore don't qualify as daytraders in my definition.
No training is required for people who are trading on-line. While they
may use a "level-2" screen that show which market makers are buying and
selling a particular stock, and at what prices, their orders are routed
by their broker who who chooses which market maker will be on the
other side of the trade (i.e. the counterparty.) This order routing is
called "order flow."
Typically, the broker gets a fee back from the counterparty in addition
to the commission from the buyer. This is how some brokers are able
to provide commissions on market orders of something like $4 per
trade. Their costs are being taken care of by the market maker,
(who is naturally taking advantage of the order flow to make the
"spread".)
There really isn't anything unethical about taking advantage of
order flow. As a daytrader, I take advantage of it all the time.
The way the economists put it, I am providing "liquidity" to
the market, and there is a value to that. I think that people
who are long term buyers and sellers of securities should
either place long term buy and sell limit orders, or should go
ahead and place market orders. I don't think they should try
to finesse limit orders, as they do not have the tools or skills
to make a profit doing this.
E-Trade, by the way, is currently offering a $75 bonus to people
opening new accounts right now. Their commission of $20 for
Nasdaq trades is quite cheap for larger share sizes (i.e. well
above 1000 shares) but is quite expensive for small share sizes
(i.e. 200 shares or less.) Ameritrade currently has a commission
schedule with market orders at $8, and limit orders at $13 per
trade. These prices are quite cheap, and are better than all but
the smallest transactions done on a direct Nasdaq account.
They are particularly good for large share size. A couple of
links:
etrade.com
ameritrade.com
But one has to remember that these low commissions can
only be provided by a company that is selling (or internally
taking advantage of) order flow.
Trading offices that provide Nasdaq direct connections do
not provide order flow to anyone. Instead, the customer
chooses where to send his market orders. In addition, the
customer can place limit orders to take advantage of
other people's market orders.
WHAT IS THE NASDAQ MARKET?
I should explain how the structure of the Nasdaq market
works with respect to limit and market orders here. The
market is a lot more complicated than nearly everybody
thinks.
Limit orders are what provide structure to the market.
Without them, there would be no trading, because prices
would not be able to be set. Basically, a trade occurs
when one person agrees to make a trade at a particular
price (the limit order) and another person takes him up
on it (the market order).
Generally speaking, limit orders to buy are placed below
the lowest limit order to sell, and limit orders to sell are
placed above the highest limit order to buy. If orders
are placed outside those limits, an opportunity for
arbitrage is created. Arbitrage is the simultaneous
buying and selling of the same thing for a profit. You
would think it couldn't happen, but if you watch the
market very closely, it happens quite frequently.
If you subtract the price of the highest limit order to
buy from the price of the lowest limit order to sell,
you get what is called the spread. Normally, the
spread is positive, when it is negative, an opportunity
for arbitrage exists, and traders will buy from the lowest
limit order to sell, and sell to the highest limit order to
buy until the arbitrage opportunity is eliminated.
The Nasdaq market has a set of computers that
keep track of the limit orders placed by various
market makers and ECNs. An ECN is an "electronic
crossing network." The ECNs are similar in many ways
to the market makers, except for technical differences
that only traders know about or care about. The market
keeps track of the limit orders available from the various
market makers and ECNs. In addition to the prices, the
computers also keep track of the amount of shares the
participants are willing to buy or sell. This is known as
the "size."
WHAT ARE LEVEL II QUOTES?
The information from the Nasdaq computers, showing
the market participants and the prices and quantities
each is willing to deal a particular stock at, is known
as "level-2" stock quotes, and is available to all the
players. It is also available on the internet. Prices,
quantities and players are constantly changing. By
watching the quotes, you can determine that Goldman
Sachs is trying to get rid of WXYZ stock, for instance,
or that Merril Lynch has a huge order to buy ABCD.
This information is available to the market participants,
and is also available to the general public. It is considered
valuable, so you have to pay to see it in real time. But
a company has recently began offering to show you
the level-2 data delayed by 15 minutes at the following
link, if you are interested, you have to fill out an
account form at:
tradescape.com
(Hit the "free streaming level II quotes" button)
The level II information provides traders a way of guessing
how much buying or selling would be required to move
the stock price higher or lower. If there are a lot of
market participants waiting to sell the stock at slightly
higher prices, it is likely that a moderate buy order will
not move the stock much higher. On the other hand,
if there are very few market participants willing to sell
at the next few highest levels, then a relatively small
buy order may result in a large price move. This is why
the level II information is so useful.
The actual number of limit orders available on a given
stock is much larger than the number shown in the
level II quotes shown on the Nasdaq computers. Each
market participant only shows his highest buy limit
order and his lowest sell limit order. The remaining
orders are kept secret from the other market participants.
If you have a relationship with a market participant, or
if you are a market participant, then you may be able
to see more, or even all of their limit orders. For example,
the office I trade shows the ISLD order book. So in addition
to seeing the best prices from ISLD, like all the other traders
in a stock, I can also see what kind of prices people are
waiting to buy or sell at. This is again useful for estimating
how far a stock is likely to move.
In addition to the level II information, traders watch the
"prints." Prints are indications of stock transactions.
Whenever anyone buys or sells a Nasdaq stock, they
are required to report it to the Nasdaq, which then passes
the information along to the subscribers (i.e. traders).
Prints include the price and the amount of shares.
It is useful to be aware of the prints, because they can
indicate whether there is currently buying or selling
interest in the stock.
All this is a lot more information than is available to
the regular retail stock client. Typically, he only gets
level I quotes. In addition, his quotes are not "streaming."
That is, he has to request each update. Streaming
quotes means that the quotes are changed with each
change recorded in the Nasdaq computers. The streaming
level-2 quotes on a high volume, high volatility stock (like
AMZN) are amazingly fast. Newly issued IPOs can
generate incredible amounts of quotes. The level 2
information is even more dense, since more information
passes by than just enough to get the buys and sells
completed. For instance, traders with limit orders are
constantly cancelling their orders without any buying
or selling.
Note that I have not mentioned anything in the above
about the big boards - NYSE and ASE traded stocks.
This is because these markets use a specialist. The
information about limit orders is kept secret by the
specialist. So the other market participants have
much less of a chance to make money.
THE TRAINING OF A NASDAQ DAYTRADER.
It is not possible to directly trade Nasdaq stocks without
training, or at least a good bit of book reading. On the
other hand, most of the daytrading firms (that provide
offices/connections for daytraders) do not provide training
to the traders (i.e. customers). Instead, the customers
learn from the other traders, typically paying a few
thousand dollars for the priviledge. Sometimes a trader
will form a small business to train other traders. As with
any other small business, some of these trainers are
good, some are not.
The training consists of how to execute trades. A retail
stock account typically has four buttons to execute a
trade, "buy", "sell", and "short." The majority of
retail stock investors never touch the "short"
button. In addition to buying and selling, the retail
investor needs to make sure that he has sufficient funds
in his account, that he can deliver share if they're not
there, that he can borrow shares if he wants to sell
short, and can choose between a limit order and a market
order. Daytrading is far more complicated. Something
like 12 diferent buttons can correspond to the single "buy"
button of the retail customer. Instead of simply buying,
the daytrader typically chooses which market participant
to buy from. He can also place limit orders on ECNs,
and can choose whether or not to have those limit orders
shown on the Nasdaq. He can also, typically, place
limit orders at prices that the retail client cannot use,
prices between the minimum 1/16th spread of the
Nasdaq. Daytraders cannot also do a lot more illegal
things with their accounts than a retail investor, and
consequently, daytraders are held to much higher
standards. Daytraders are typically held responsible
for trades they did not intend, even though the error
was due to equipment malfunction of the trading
office. Daytraders can also have trades cancelled,
if their price was too much outside the market prices
at that moment, and have to worry about having trades
cancelled against them. When a daytrader violates
rules, he gets fined a small amount (assuming that
the violation was accidental, as is typically the case).
The most common violation, I suspect, is shorting
a stock that cannot be shorted. Daytraders, like
retail investors, have to verify that a stock is shortable
before shorting it. But the process is faster for a
daytrader, who typically knows that which big issues
have already been okayed by the office for shorting.
WHAT IS A MARGIN CALL?
The retail investing public is quite familiar with retail
margin calls. These typicall occur when an investor
purchases more stock than he has cash, and then
the stock goes down in price. The current SEC limit
on margin is 50%, so an investor with an account
having $100 in cash, can buy up to $200 in stock.
After purchase, the investor does not need to maintain
50% margin, but he must maintain some smaller
margin percentage. Companies change margin
requirements on stocks frequently, AMZN has recently
been changed to 100% margin at Charles Schwab.
This means that investors are not allowed to borrow
any money at all against their AMZN holdings.
Margin maintenance is checked at the end of each
day, and depends on the closing values of the stocks
borrowed against. If the margin held by the investor
declines below the margin maintenance requirement
of his broker, he will receive a "margin call."
Daytraders are supposed to exit their positions at
the end of each day, though this is not a requirement
forced on them by the offices that they trade at. But
in addition to having a limit to how much stock a
person can own at the end of a day given how much
equity the person has, there is also a restriction on
how much stock a person can own (or be short) at
any time during the day. This restriction is sometimes
violated by daytraders, and this is the nature of a
daytrading margin call.
Note that simply buying and selling (or shorting and
covering) the same stock over and over does not
of itself generate a margin call. Instead, the margin
call is generated if the total amount of stock held
simultaneously exceeds the buying power of the
account.
One of the rumors of famous margin calls that
circulates around the daytrading community is that
of the guy with a $100,000 size account who bought
several million dollars in stock. He did it on the day
that the market was rebounding from a panic low. He
never really put the office at risk, because he
didn't open any new positions until his old
positions were quite profitable. But he kept on
pyramiding his positions that day. Before the
end of the day, he closed everything out with a
profit in the $100,000 area. The office told him not
to do it again, and, in addition, he generated a massive
margin call.
A daytrading margin call has to be satisfied within
5 business days. The daytrader can have money
transferred into the account overnight. That is,
the money can be transferred after the market
closes on one day, then transferred out before
the market opens the next day. This is relatively
risk free to the lender, providing that the trader's
account doesn't have some sort of unusual problem
overnight, so this kind of money is readily available
to borrow. Interest rates are typically 18% for
such a loan, but since the money only needs
to be borrowed for one day, the actual cost is only
0.05%. In addition, the loan is good for covering
5 business day's margin calls, so the actual cost
to cover margin calls is an annualized 2.6%. In
addition, the margin call is for only half the amount
that buying power was exceeded, so the actual
costs to a daytrader to borrow money to cover
intraday margin calls over the course of a year
is about 1.3% per year. Typically, in daytrading
offices, the traders provide overnight loans to each
other in order to cover these sorts of margin calls.
Anyway, I noticed that the shooter in Atlanta was
supposed to have killed traders who had loaned him
money. My guess is that the loans were of the
intraday margin call type. A trader would have to
be quite out of his mind to loan money to another
trader to cover a retail type margin call. This is
particularly true of the concept of loaning money
to a beginning trader. The vast majority of them
wash out, so such a loan is highly unlikely.
I have seen traders loan each other money for
trading, but only in order to get their account
above the minimum amount to begin trading.
I wouldn't make these sorts of loans either,
but they are somewhat safer. As an example,
a trader might have $10,000 and needs to borrow
another $10,000. So another trader loans him
the money with the agreement that if the account
equity gets below $15,000 the loan is to be
repaid and the account closed. These are
relatively safe loans, provided the trader doesn't
declare bankruptcy on you, but I still don't think
they are very good ideas.
HOW DO TRADERS LEARN TO TRADE?
One of the facts about the Atlanta shooting is
that the suspect managed to lose a huge amount
of money in a very short time while trying to learn
daytrading. He must have broken every risk
management rule in the book. Sadly, this sort
of activity is not uncommon. In fact, my guess
is that this is the fate of a good 50% of the people
who try daytrading. Most of the remaining 50%
lose their money more slowly, and eventually
get the idea to move on. The odds are not in
favor of the beginning daytrader. My own guess
is that 95% lose money.
A beginning daytrader has a huge number of
lessons to learn. The first lesson, and the
one that must be learned quickly by any
trader, is how to stay in the game. That is,
how to avoid losing money quickly. This lesson
is more important than learning how to make
money quickly, because there will inevitably
come a time when a daytrader will make a
sequence of incorrect trades. He must ensure
that a sequence of bad trades will not damage
his account (or his ego) enough to get his account
closed, or destroy his concentration.
STAYING IN THE GAME
The way to avoid having a sequence of bad
trades take you out of the game is quite
simple. You must never risk more than
1% or if you are very certain, 2% of your
account equity on a single trade. This
limit seems so restrictive to beginning
traders that they almost inevitably ignore
it completely. But it is the result of years
of experience in the analysis of trading
behavior and is supported by mathematical
calculations in the field of proability. If the
prospective daytrader has the mathematical
skills, he can read the books on the subject.
Otherwise, he will have to take the expert's
judgement.
This 1 to 2% trading limitation applies to all
sorts of trading, not just daytrading. Plenty
of successful traders violate this rule all the
time, but over time, traders who violate this
rule get weeded out of the market. Sometimes
people who are famous for their trading skill
violate the 1% rule, and end up out of the game.
The most famous recent case is Victor Niederhoffer.
Victor Niederhoffer wrote the book, Education of
a Speculator in 1997. It was on the best sellers
list for nonfiction for some time, and is a classic
among trading autobiographies. His preface,
written in November 1996, has the somewhat
prophetic writing:
A friend, after reading an early draft of this
book, wrote me this agitated message:
"[I] respond[ed] to it with great concern. It's
obvious that it's only a question of time until
you go under. Why in the world would I ever risk
money in the futures market, and, if I ever gave
in to such folly, why should it be with Niederhoffer?
I know that must come across harshly, but I thought
it better to put it that way rather than sugarcoat
it."
The market decline of Monday, October 27, 1997
took Niederhoffer out of the game. His three
hedge funds, Limited Partners of Niederhoffer
Intermarket Fund L.P., Limited Partners of
Niederhoffer Friends Parntership L.P. and
Niederhoffer Global Systems S.A. were wiped out,
with losses estimated at $50 million to $100
million. The limited partners lost all their
money. Must have been a bummer. Anyway, this
is where traders eventually go if they fail
to obey the 1 to 2% rule, though they usually
go there in a less spectacular fashion.
Some book links:
Vince's The Mathematics of Money Management:
Risk Analysis Techniques for Traders
shop.barnesandnoble.com
Niederhoffer's Education of a Speculator
shop.barnesandnoble.com
Beginning traders, who don't have an "edge"
against the market, go broke a lot faster
than the old pros, and this is undoubtedly
what happened to the Atlanta shooter.
LOOKING FOR AN EDGE
Once a beginning trader learns to not risk
too much on a single trade, he must then begin
to look for an edge against the market. Like
in gambling, an "edge" is an advantage that
will allow him to take money out of the market.
Edges are not easy to find. Once found, they
tend to be exploited by more and more people
until their value becomes almost nil. For
this reason, a daytrader has to think in terms
of very small advantages. The big edges do
not exist in the market, only in the
imagination of naive traders.
It is hard to give up these dreams of easy
money, even for experienced traders. Everyday,
the market proves that if you only buy and
sell the correct stocks in the morning, you
will have plenty of profits in the afternoon.
But a professional trader has to ignore these
mirages, and stick to the trading where he
has an edge.
Even experienced traders spend time looking
for new edges, and sharpening the ones they
have. Edges are hard to find, and jealously
guarded. Traders are not likely to explain
their edges to you, if those edges can be
exploited by other people. Since trading
advantages are always small, you can only
detect edges by looking at large amounts of
data. Data can be obtained by either looking
at past stock price histories, or by actually
trying a new method.
For people that trade on longer terms, stock
histories are a good source of data for edge
searching. But the faster a trader trades,
the less useful stock histories are. The
reason for the difference is that very short
term trading depends too much on the exact
details of how the trade was entered, and
this kind of thing cannot easily be predicted
by looking at historical data. In fast moving
markets, a lot of the data shown by a level II
quote system is stale. That is, the quotes
shown are not real. This is the case because
the market makers frequently do not remove
their quotes until up to 15 seconds after
they have already filled the quote.
For traders who intend on trading long term,
a Nasdaq workstation with level II quotes
is probably a waste of money and effort. They
should instead use a retail broker. So
traders that use Nasdaq workstations to trade
with are more likely to need to test edges
through actual trading.
Testing an edge through trading can be expensive.
Altech charges $20 per ticket commissions, so
buying and selling a stock costs $40. There
are much better deals out there, particularly
for beginning traders. In fact, MBTrading
is currently offering a deal where traders
can pay 5 cents commission per share for their
first 60 days. While this would be a very
expensive commission on 1000 shares, someone
testing an edge is likely to want to trade
only 100 shares, the smallest round lot, and
pay only $5 per ticket.
For a scalper who wants to learn to make 30
trades per day, the total commission cost
will be $300 per day. In addition, he will
either gain or lose money against the market.
But assuming that he is even against the
market, he can expect his costs for trading
30 trades per day for six months to be about
$30,000. This is not that huge of an amount
of money, when it is compared to the cost
of getting an education in other well paid
fields. Note that MBTrading's deal is only
for 60 days. I don't think 60 days is long
enough to learn how to trade, though some
people will, no doubt, learn that quickly.
At Altech, the commissions are $20 per
ticket, so this same six month education
would cost $120,000. This is more money
than most beginning daytraders are willing
to pay to learn.
BEGINNING TRADER'S BIGGEST PITFALL
The typical response by beginning traders
to the tough commission schedule at Altech
is to trade less. This is simple economics.
But in order to keep the dreams of the big
profits, this means that they have to take
bigger risks on each trade. Typically,
what they do is to begin holding trades
for longer time periods than Altech suggests,
even overnight. The newspaper reports suggest
to me that this is what the Atlanta shooter did.
What beginning daytraders that drift into
long term trading usually do is to sell stocks
when they are profitable. They will take
stocks that decline in value, and simply
wait until they come back to sell. If
the stocks they hold decline enough, and
they have borrowed enough money on them
(I.e. own stocks on margin) their account
equity can decrease considerably.
All trading offices will prevent a trader
from trading if his equity declines below
a certain amount. Under such a condition,
the trader can only close his open postions,
not open any new ones. A lot of trading
offices will also prevent a trader from
trading if his percentage loss for a month
is too large. I believe that this is a policy
that Altech has. So my guess is that the
Atlanta shooter was barred from trading at
Altech due to excessive equity loss, (no
doubt caused by a combination of trading
too many shares and holding for too long
a time) and then opened up an account
at Momentum.
Another way that people get hurt daytrading
is from the gambling mentality that they
bring into the profession. The worst are
the ones who increase their "bet" when
they are losing. The idea is that they
just want to make bat their loss, but
traders have a strong tendency to "streak."
That is, a trader is more likely to have
positive trades followed by positive trades
and negative trades followed by negative
trades than chance would indicate. This
tendency to streak is taken advantage of
by some daytraders. They increase their
share size, (and therefore the amount of
their "bet",) when they are winning, and
decrease their share size, (or quit playing
and go home) when they are losing.
But humans would rather have a winning
day than a losing day, so they tend to
increase their share size after losing.
When they fall into the inevitable series
of losses, the increased shares size makes
the damage that much worse. It is not
unlikely that the Atlanta trader did
this, it is quite common.
The sort of thing that happened to the
Atlanta guy's account is quite common among
beginning daytraders, though his response
was more violent than anybody else's. But
finding stories of people who lost it all
daytrading will be very easy to do. In fact,
all highly-rewarded occupations have a high
wash-out rate. How many high school graduates
go to college with the intention of becoming
doctors? How many kids try out for football
with the intention of playing for the NFL?
How many people play in amateur rock and
roll bands? It is human nature to strive
for a better living, particularly in a
profession that they enjoy.
PROFITS OF DAYTRADING
But there is no question that daytraders,
as a whole, are profitable. The reason
is that the ones that are profitable tend
to increase their trades and the size of
their trades until, as a group, they make
up the bulk of the trading done by
daytraders as a whole.
No more than 5% of the people who try daytrading
succeed at it. But that 5% keeps daytrading
for years, while the failures quit in a matter
of months or even weeks. For this reason,
the percentage of people daytrading who are
making money is much larger than 5%. It is
probably more like 50%, and they are probably
responsible for 80% of the daytrading volume.
These numbers are my guesses, but my guesses
are educated by observation of trading
patterns. It is unlikely that anyone is
going to release the actual statistics,
though a daytrading firm might do so.
THE POLITICS OF DAYTRADING
Those daytrading profits are being
extracted from somewhere in the economy,
and it is natural to ask "who pays?"
Daytraders generally extract their profits
by providing liquidity to the market, just
as the big market makers do. For this
reason, the daytrading profits are
extracted from the pockets of the firms
responsible for large amounts of trading
profits. These firms typically are high
profile and would like nothing better than
to see the end of daytrading. Their internal
trading floors do the same thing as independent
daytraders, with some advantages and disadvantages,
and there is nothing they would like better than
to eliminate the competition. For this reason,
I would expect to see these companies suggest
changes in the law that would work to elminate
daytrading.
It would probably be useful to educate
the general public as to what daytrading
is all about.
-- Carl |
