Wednesday, January 23, 2008

Do Individual Day Traders Make Money?

Trading lore has it that the average trader loses money in the markets. Some estimates put the proportion at 80% or even higher. When we think of all the potential disadvantages of the individual day trader, it's not hard to believe those numbers. After all, the individual day trader as a whole:

* Does not participate in the long-term upward drift in stock prices exhibited by equities;
* Does not have a team of analysts providing researched trade ideas;
* Does not have a dedicated IT and programming staff to support and automate trading;
* Does not have a rich array of colleagues to share ideas and learn from;
* Does not have access to the best trading software and news services;
* Does not enjoy preferential commission rates available to exchange members.

Those are formidable obstacles. But what does research tell us about the success of individual day traders?

A 2004 study from Brad Barber, Yi-Tsung Lee, Yu-Jane Liu, and Terrence Odean was noteworthy in that it studied the complete transaction history of the Taiwan Stock Exchange over a five-year period. From that mass of data, they were able to identify specific market participants and categorize their trading as day trading vs. investing. Moreover, they were able to separate active day traders from others.

Interestingly, day trading accounted for 22% of the volume of individual traders, but only 5% of the volume of institutional participants. Moreover, volume in day trading is highly concentrated in their sample: the 1% of largest day traders accounted for half of all day trading volume.

The major conclusion of the authors is that "day trading is treacherous, but not entirely a fool's game." Specifically, "a large fraction of day traders, more than eight out of ten, lose money, though a small fraction of day traders earn large persistent profits." Not surprisingly, the heaviest (largest) day traders were most likely to be profitable; as a group they made money before transaction costs but not after. The smaller, less active day traders lost money even before transaction costs were factored in.

I believe that the results of the research suggest a Darwinian mechanism at work. The largest day traders are likely to be the best capitalized, and hence the best able to survive their learning curves in markets. The most active day traders are also those who are most apt to lose their money simply due to the cumulative impact of slippage and commission costs. The least active traders (part-time, occasional) get the fewest looks at markets and hence are least likely to learn and internalize pattern recognition skills essential to day trading. This creates a selection mechanism in which a relatively small number of large, frequent day traders survive to dominate volume and profitability.

So what keeps new traders coming to an arena in which far fewer than 20% of participants are profitable after costs? Odean's research suggests that overconfidence plays an important role. Just as participants in lotteries and casinos overestimate their odds of winning, individual day traders may place too much confidence in their ability to read market patterns out of the gate. If that is true, the majority of individual day traders should fail relatively early in their careers, something that has been mentioned to me by executives at brokerage firms.

But this only scratches the surface of the authors' findings regarding success and failure in the day trading arena. My next post in this series will take a closer look at what separates the winners from the losers.


Overconfidence and Underconfidence in Trading

The Most Common Trading Problem

Why It's So Easy to Lose Money in the Markets