Part III
Day trading arose from the rubble of the October 19, 1987, stock market crash, when stocks went into free fall and frantic investors who tried to sell couldn't get in touch with their brokers, who had stopped answering the phones.
Harvey Houtkin was ruined that day. He was an arbitrageur -- someone who trades stocks or commodities to profit from the gaps between the value of stocks or commodities prices in different markets. His firm, Domestic Arbitrage Group, was wiped out after customers failed to pay up. Despondent, Houtkin sat in a deserted trading room that had once buzzed with 70 people. "It was as though a neutron bomb hit," he says. "Everything was there -- the machines, the desks -- but there were no people." Adding to his despair: His father was dying from leukemia.
Within three months, he and his brother-in-law started a new firm, All-Tech Investment Group Inc., on the same premises. Houtkin began to do a little trading, making an eighth of a point here, a quarter of a point there. He was having trouble getting reliable prices, however, and felt he was getting ripped off on every transaction. Houtkin could see it because, unlike the typical investor, he was sitting in a trading room and could see what is known as a Level II. Level II is a screen that lists all pending bid and asking prices by broker dealers on the National Association of Securities Dealers Automated Quotation system, or Nasdaq. Unlike the New York Stock Exchange, where specialists on the floor of the exchange balance orders from brokerage firms, the Washington-based Nasdaq market is an enormous computerized network.
"If there was a movie, this is where the sky would open and angels would come down and dance," Houtkin says. He realized that he could take advantage of a little-known and rarely used mechanism called the Small Order Execution System, or SOES, which had been designed by Nasdaq in 1985 to give users instant access to prices for trades of 1,000 shares or fewer. Executing trades was cheap, and Houtkin took away the extra fractions that brokerage firms usually shaved off for themselves. All-Tech was pressured by Nasdaq to end the practice, and in the securities industry Houtkin and his ilk were soon branded "SOES bandits."
The epithet didn't bother him. "I no longer had that allegiance," says the Brooklyn native. "I no longer had that camaraderie with this industry I was part of for 20 years. I was not going to sit there . . . while they got away with it."
Eventually, the Securities and Exchange Commission brought a giant price-fixing case against major brokerage houses, which ended up paying $900 million in fines and damages in a 1994 settlement.
Far more threatening to the big houses, however, was the change in the pricing of securities for ordinary investors. The settlement between the SEC and the brokerage firms widened access for ordinary investors to SOES and other electronic clearing networks, such as Instinet or Island. That handed the small trader greater power to get the best prices available. "Before, you could not participate in the markets. The game was slanted so much against you, it was impossible," Houtkin says. Now, "you can lose money, but at least it is because the market went against you and not because you got screwed by your broker."
The SEC investigation and eventual settlement also spurred growth for firms like All-Tech, which was able to end its battle with Nasdaq and woo new customers. All-Tech went from having a handful of traders who were friends of Houtkin, to today having 25 branches and 2,000 customers, half of whom work from home and half of whom work from All-Tech offices. Brokerage fees have plummeted, making it possible for ordinary traders to buy and sell, make relatively small profits on each trade and still cover the commissions they pay to day trading firms. All-Tech's typical customer trades five to 10 times a day, but many trade as often as 100 times a day. Together, they buy or sell 5 million to 6 million shares a day and generate about $50 million a year in fee revenue for All-Tech.
It was to All-Tech that Lawrence Black went to learn the rudiments of day trading.
When Lawrence was a freshman at James Madison, his parents, Kenneth and Larrilee Black, handed over to him three years of tuition, money they had received in trust from his late grandmother. Lawrence went to put the money into certificates of deposit, but an officer at the bank persuaded him to look into stock mutual funds. He bought. Then he started buying individual stocks. Between classes, he'd use pay phones around campus to call the Charles Schwab brokerage and trade. Although he wasn't a great success, he became hooked on the idea of trading stocks.
When he graduated, he journeyed to All-Tech's offices in Montvale, N.J. All-Tech was the pioneer in SOES trading and had the best computer connections. Lawrence had read about the firm and called Houtkin and talked to him for an hour after seeing him interviewed on CNBC. After borrowing $60,000 from his mother to add to $10,000 of his own money, Lawrence paid $5,000 for a course from Houtkin and put down a bit more than the minimum $50,000 to open a trading account.
Giving that much money to her son wasn't the sort of gamble Larrilee Black ordinarily takes. "I won't even put a quarter in the slot machine," she says in an accent tinged with her native Atlanta. "My girlfriends like to do that. I always took $30 to Pimlico. I could lose that, and I always did." Still, she says she had faith in Lawrence. "Well, I wouldn't have loaned it to a stranger," Larrilee says.
In Montvale, Lawrence stayed in a Ramada Inn on good days, a cheap motel on bad ones. As his losses mounted, he rented a room from a woman for $75 a week and shoveled the snow from her walkway. Soon he lost most of what he and his mother had put in. He nearly stopped trading. His mother was blissfully ignorant. He didn't tell her how much he had lost.
After three months, however, things started to turn around. Lawrence started making modest profits. He moved back home after All-Tech acquired technology for people to trade from home. He set up his computer in his parents' basement, which is covered with leopard-pattern wall-to-wall carpeting and decorated with Nigerian Senufu masks, Ghanaian Ashanti statuettes and other African decorations that Larrilee adores. Gradually, he started making serious money. High school friends used to come over to shoot hoops; they'd look at his setup and ask if the money was real.
"When I got home, I thought I was the luckiest man in the world," he says. And why not? He wasn't paying rent. He didn't have to prepare his meals. His laundry was done for him.
As the profits became steadier, Lawrence persuaded his mother to hire a lawn service so he wouldn't have to stop trading to mow the lawn, and a cleaning woman to tidy the house. "That was the first luxury I ever had," says Larrilee Black. "I want to know when I get a new car or a new coat," she teases him.
Today, Lawrence uses the basement office for after-hours research on stocks he's thinking about trading. The basement has a few special touches, in addition to the carpeting. Four packing boxes full of trading records sit on top of an unused bar area; he'll need them later to undertake the monumental job of preparing his taxes. A photo of Houtkin sits on a desk.
On a wall hangs a certificate for a single share of stock in a company that Lawrence bought before he went to Montvale. Convinced that the company had tremendous growth potential, he had bought 10,000 shares at $3 a share. The stock soared to $9 a share and Lawrence thought he had a piece of the next Microsoft. When he got to Montvale, he noticed the company's symbol flashing by. It had dropped to $3 again. Later, the stock did a reverse split, a technique for failing companies to stay within the listing requirements for the Nasdaq exchange. Eventually it became practically worthless. Lawrence sold all the shares except one; he keeps the certificate as a cautionary reminder.
The certificate serves another function, too. It covers a hole where Lawrence heaved a telephone through the wall after making a particularly bad trade. Then there was the lamp he broke.
Lawrence frequently browses in online chat rooms about stocks, though he doesn't place much value in them. "They're almost a contrary indicator," he says, because people often bad-mouth stocks they have shorted. Back in 1996, he used to write in and say that a stock he held was the greatest buy on earth. "There are enough people doing that now," he says.
Indeed, so many people are doing it that the Securities and Exchange Commission has been paying closer attention to people who "pump and dump" stocks -- talking up shares they own before selling out and without telling readers of their interest.
Mostly, Lawrence studies charts, trying to spot familiar patterns that suggest when a stock might "break out" or "break down." Stocks that seem to bounce along a floor and then start heading up to new highs -- looking a bit like smiling faces -- are the ones he finds most promising.
His mother remembers the bad days -- and the broken lamp. "I still have it," she volunteers and offers to bring it downstairs. Lawrence squirms.
"Mom," he groans, "I'll buy you a lamp store."
Day trading violates all the rules brokers tell you about investing. Washington Post columnist James K. Glassman says the ideal amount of time to hold a stock is "forever." Fidelity Investments legend Peter Lynch advises investors to look for companies whose products they know. The seer from Omaha, Warren Buffett, buys chunks of companies and holds them for years or decades.
"Warren Buffett, the endlessly quoted guru of buy and hold, made his billions from buying stock in companies like McDonald's and then taking twenty year naps," stated Lawrence in a short book, The Microtrading Revolution, he co-wrote on day trading. "Warren Buffet could be described as the antithesis of micro-traders who often buy and sell stock in less time than it would take Mr. Buffett to eat a single chicken McNugget."
Day traders don't care a whit about a firm's underlying value; they care about its momentum. If a stock is overvalued, but heading higher, the day trader will buy it.
"It's not where a stock's been, it's where it's going," says Hawley. "We're thinking, if it's up $10, it can go up $20. Most people are thinking: If it's up 10, it should pull back."
As a result, day traders rarely think about pedestrian indicators, such as price-to-earnings ratios, that most investors look at. Normally investors look for stocks with P/E ratios in the 15 to 20 range. "Sometimes I'll buy a stock with a 4,000 P/E," says Lawrence, "because before it had a 2,000 P/E and soon it might have an 8,000 P/E."
If done consistently, riding stocks' momentum can be profitable. "Eight times out of 10, if a stock hits a new high and high volume, the chances are good that it will go 20 percent higher," says Hawley. "That's just the law of averages."
It isn't quite that simple, of course. The typical day trader's initial kitty is usually wiped out within three months. Houtkin estimates that one in three people survive to become full-time day traders; one of All-Tech's regional managers estimates the figure to be more like one in 10.
On a recent "60 Minutes" segment on day trading, one trader who lost $200,000 blamed firms like Houtkin's for collecting commissions while watching him ruin himself. Houtkin responds: "All I'm doing is creating a mechanism for people to access the market. That doesn't mean you'll make money. I don't tell people what to buy and what to sell, how much to buy and how much to sell. I'm not their father. I'm not responsible . . . If you're stupid, you're stupid. That's basically the bottom line. Whether that guy was in the market or bought swamp land in Tennessee, he was going to lose money."
Houtkin compares the technology that allows ordinary investors direct and instant access to the stock market to a high-powered rifle. "If you use it right, you will be able to hunt effectively and bring down a nice buck and feed your family. But if you don't know what you're doing, you'll probably blow your head off."
In All-Tech's Falls Church branch, one of the many losers takes a few minutes to chat about her misfortune -- on condition that her name be withheld. Her family does not know the extent of her losses, she says. Turned on to day trading by a friend, the thirtysomething woman took money she had received when she sold her own small business. Within a month, she had lost $40,000. Three weeks later, she had made it back.
"Then I made $28,000 in a day and said, 'Wow, this is great,' " she says. "The quick buck, that's what appeals to everybody. The days you come in and make twenty grand, it's exhilarating. I kind of got addicted to it."
Like most day traders, her specialty is Internet stocks. Not that she knows anything about them. "Most of the time I don't know what they do. They're moving, that's all I know," she says.
Then she stumbled. She bought some stocks on margin -- borrowing to make the purchases -- and held the stocks overnight. That night, Brazil devalued its currency and the next day, world stock markets were pummeled. She lost $200,000 in a day, wiping out the money she had made from the sale of her business.
After that, she took some time off. She looked for jobs but decided she didn't like the hours.
In mid-March, she dipped further into her savings and went back to All-Tech. "I didn't want a real job," she says. Besides, day trading "really does suck you in . . . It's like video games or gambling, only you have more control this way."
Maybe. "Damn," she says, interrupting herself. Two trades she has are turning against her. The market closes and she's still holding two stocks, breaking two of the cardinal rules of day trading: Get out of losing trades quickly, and don't hold stocks overnight. "I don't have any choice," she says. "You know what they call a trade gone bad? They call it an investment."
Tales of woe tend to be drowned out by the lure of quick riches. One chilly night in February, a small group of potential day traders travel to Bright Trading's offices in Bethesda.
Ronnie Friedman, a real estate broker, says she is tired of working as a "taxi driver" for home buyers. Her "babies" are grown, she says. "We're done with tuition, dentists, camps. We want to play catch-up on retirement." Her goal: make about $50,000 a year.
Her son works at a trading firm, though he has tried to dissuade his parents from following his lead. "He says it's a video game," says her husband, Donald, a developer. "So, it's a million-dollar video game."
Ronnie asks whether a couple can share an account and alternate days at the computer terminal. "I buy easy and he sells easy, so we work out," she jokes.
Terry Allen, the manager of Bright's Bethesda office, sounds a cautionary note. "People are naive about the success ratio," he says. "They think they are just going to waltz in and make money. There's no other job you can go to and lose money. It's a very tough job."
Allen encourages people to go to Bright's main office in Las Vegas for a week-long course even if they have invested in stocks or used electronic brokerage houses. "Trading is not investing," he says. "Some people try to hit home runs all day long. It's better to hit singles and doubles. You can make eight or nine great trades and then do something stupid and it ruins the whole day . . . People who come in and try to make a killing are not going to make it. It's not a get-rich-quick scheme. There's a high burnout rate. But it's fun, too."
"It takes discipline, discipline, discipline," advises Bill Rooney, a former computer consultant who has been trying his hand at day trading at Bright since December and has stayed to talk to the newcomers. So far he's losing money, though in relatively modest amounts. "I had a really bad day, but I know what I did wrong. A month ago I didn't know that," he says. "I'm willing to pay some 'tuition' to get the mechanics down."
A smartly dressed younger couple listens carefully. Al Espinoza, 32, a computer consultant who says he's a numbers guy, has traded on E-Trade, the electronic brokerage, and has a hankering to get into day trading. He usually holds stocks for less than a month, and some for a year. "He likes to play," says Dawn Trckla, Espinoza's fiancee, who does hair and makeup for a television station. But Espinoza is cautious. "I understand that it can affect your life. You lose and it puts you in a mood that's worse than it should have been. You've got to control the monster."
The monster ate Lawrence Black's girlfriend. An environmental consultant who spent two years building latrines in the Dominican Republic for the Peace Corps, she told Lawrence he had lost his soul. Sometimes when they went out to dinner, she felt he wasn't paying attention. "She could tell I had charts in my head," Lawrence says. A photo of the two of them still adorns his desk at home.
These days his closest pals are at Net Trade. After trading one day, they are sitting in the bar bantering. The friends are ribbing Lawrence about his penchant for smashing computer mice. At least they're attached to a cord and not flying across the room, he says. Once, Lawrence says, before they started warehousing mice in the office, he made a bad trade involving Amazon.com and smashed the computer mouse. Then he saw that he still had 800 shares and was losing more money by the second. So he crawled around on the floor trying to pick up the pieces, while his friends laughed.
Hawley says someone should manufacture a Furby-like doll that you could throw against the wall and it would say things like "You're a genius!" or "Nice trade!"
Lawrence and Hawley teamed up to write The Microtrading Revolution. It is, by Lawrence's own admission, "overpriced" and resembles a pamphlet. It bears a few of Lawrence's touches, like famous quotations. A chapter on "How to Choose the Right Microtrading Firm" begins with these words from John Keats: "I would sooner fail than not be among the greatest."
The book has sold fairly well on the Internet. Now it's listed on Amazon.com, but the comments from readers have been mixed. One reader called the price "nigh-robbery." Another said, "I have read approximately 24 books on trading in the last four months, spending in excess of one thousand dollars. This, I am sorry to say, is the only one I sent back." Still another said, "I've read all the books written on SOES trading . . . The Microtrading Revolution is the most expensive, the shortest, the most vague, but also the most honest."
As befitting a creature of the computer age, Lawrence also has his own Web site, where he describes himself as having been "immaculately born out of the leg of a rare white elephant." For readers of the book who don't like the price, he suggests that he or Hawley can personally sign copies, enhancing their value. "For those with neutral or biased opinions," he jokes, "the complaint department has been spun off and sold to a group of well-financed Texans."
Larrilee Black, Lawrence's mother, says he used to talk about retiring at 29. And Lawrence talks vaguely about trying his hand at writing, but he seems to lack any clear plan. With day trading, he doesn't need one. Though he looks exhausted at the end of a day, he unfailingly manages to drag himself in just in time for the start of trading on another day.
On March 18, he's at it again. The first half-hour is usually the wildest. "Ebay's on a roll," he calls out to Hawley and another regular, Marcus Bowman.
Yahoo!, once derided as overpriced by analysts, has practically become a blue chip among Internet stocks. The price is hitting a new high. "A flight to quality," Lawrence says, laughing.
Soon a company called Netegrity (symbol: NETE) starts to move up sharply. Lawrence checks news wires and discovers a Business Wire article touting the company as "a hot new Internet firm" that will rival the popular Lycos. Hawley points out that a company with the symbol NETG is also rising sharply. "How much you want to make a bet that they're mixing those two up," he says. That sparks a discussion of whether, if true, it would be better to buy up NETG and ride it up, or short it and wait for people to realize the mix-up.
Meanwhile, CMGI, which rose sharply early in the morning, is starting to fall. "There it goes," says Lawrence, selling 2,700 shares short. "Drop baby!" Within two minutes his shorts are worth more than $2,000. But he's nervous and in minutes does an about-face and buys CMGI back.
Another fast mover pops up on a screen that tracks the market's biggest movers. It's called 4 Kids Entertainment. "What's that?" asks Bowman. "Maybe it's four kids and a computer.com," jokes Lawrence.
As the day wears on, Lawrence grows frustrated. He catches a small rise in Amazon stock, but mostly he's generating commissions for Hawley and Net Trade. "Lawrence tends to go from irrational exuberance to irrational gloom," says Hawley, borrowing Federal Reserve Chairman Alan Greenspan's "irrational exuberance" characterization of the stock market in 1996. "At least I'm consistent in my irrationality," says Lawrence.
On the television, a commercial for Fidelity Investments comes on. It features Peter Lynch talking about investing: "Despite nine recessions since World War II, the stock market is up 63-fold, because earnings are up 54-fold. Earnings drive the stock market. It's not that complicated."
Bowman chimes in: "The stock breaks out, you buy it, it's not that complicated."
In the afternoon, Lawrence is again trying to make money off of CMGI, whose stock surged earlier in the day after it split. But the collapse in the stock price Lawrence expected earlier still hasn't happened. People who bought it earlier in the day -- considered "long" in the stock -- are still hanging onto it.
"What's the average person out there doing on CMGI? He's long in it, and he's freaking out, right?" The stock begins to tick downward ever so slightly.
"Come on," Lawrence calls. "Break down! Break down!"
Steven Mufson covers diplomatic affairs for The Post.
Caveat Investor: 'Impulse Is Your Enemy'
For most ordinary investors -- those who think shorts are things you wear in summer and breakdowns are psychological afflictions -- the sanest guidelines to investing are just the opposite of the rules followed by day traders.
The most respected investment gurus generally advise searching for companies with steady earnings, solid businesses and good value, rather than those that are risky, volatile and overpriced. They counsel patience when it comes to stocks, and many suggest stock index mutual funds for those investors unable to manage their own portfolios in great detail.
Whereas day traders are frenetic buyers and sellers, Warren Buffett, the chairman of Berkshire Hathaway (and a major shareholder in The Washington Post Co.), has been successful largely by buying -- and holding -- companies with great franchises and brand names, like Coca-Cola or Gillette. Buffett wrote in his 1996 annual report that "inactivity strikes us as intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly profitable subsidiaries because a small move in the Federal Reserve's discount rate was predicted or because some Wall Street pundit had reversed his view on the market. Why, then, should we behave differently with our minority positions in wonderful businesses?"
"Impulse is your enemy," advises John C. Bogle, senior chairman and founder of the Vanguard Group of mutual funds. He says fluctuations in the market tend to average out and that investing early and steadily over a long period will prove a sure strategy.
"Investing for the long term is central to the achievement of optimal returns by investors," he says. When he says long term, he means 20 years, not 20 minutes.
Most investors follow his advice. The National Association of Stock Dealers says the average investor trades about four times a year; day trader Lawrence Black trades about four times every three minutes.
Among the most popular investment vehicles in recent years have been the stock index funds pioneered by Vanguard's Bogle, who created a fund that tracked the Standard & Poor's index of America's 500 biggest companies. Over the past couple of years, those companies' stock prices have risen to a level beyond what most analysts believe reasonable based on the companies' earnings. The important price-to-earnings ratio of the S&P 500 is about 34, about twice as high as the historical norm.
As a result, Bogle and others have been touting the virtues of even broader, and less richly priced, funds that are indexed to all publicly traded companies.
Most financial advisers also say individuals should invest a portion of their savings in stocks and a portion in more conservative areas such as fixed income securities like bonds. The younger you are, the more sense it makes to increase the proportion of stocks. If you're retired or nearing retirement and in need of steady income, a smaller proportion of stocks is appropriate.
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