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


jeff said...

this is a fascinatig post. I've always heard and read that the mojority of traders lose money, be it %80 or %90. But nowhere have I read some factual data to back up this truism (up until now). Thank you!

MikeH said...

No surprising, considering someone going in with no knowledge sees stories and promises of making $100s if not $1000's per trade. That gives rise to a lot more confidence that the more realistic, $1.00 or less, net, per contract traded, over a large number of trades. If you make one tick per contract, and get 10% of that as your net, you're on par with most other business ventures.

Sandor Tucakov Caetano said...

That was an amazing research...

I wish taxes in Brazil weren't so high. In terms of comissions we pay as much as a guy in Taiwan (roughly 0.15%) but we pay 15% from all our winnings in taxes :(

Paolo Pezzutti said...

I do agree.
Most of the daytrders underperform the market and often a buy and hold strategy. Lack of consistency, time, resources, weakness of the methodology implemented, commissions, connectivity, automation, etc. makes things difficult.
I think greed is what continues to attract new losers who think to approach the market and make money easily. Most of these people enter the market when it is prone to give money and they make money for quite some time. When conditions change, "wanna-be" traders do not have the ability to adapt and give back everything they earned before and much more very quickly. This is the point when most give up and do not take into account in their strategy the lesson learned. Waiting for new suckers to join the club of losers at the next bubble.

Dinosaur Trader said...


Thanks for this. I think there's a problem of definition. I've been daytrading for 9 years and all the guys I started with (minus 4 or 5) are still going strong.

So in my experience, at least 80% of daytraders seem to be successful.

If statisticians want to disparage daytrading by defining guys who were trying to catch a 50 point move in Qualcomm back in the day as daytraders, that's fine, but it definitely skews the numbers.

I mean, if I fish a few times a year and don't catch a fish does that mean 99% of fisherman fail? No, because I'm not a fisherman. I'm just dropping a line, hoping to get lucky.

Hopefully, that makes some sense.


Brett Steenbarger, Ph.D. said...

Hi DT,

I've worked at quite a few prop firms and known and worked with many traders. I can say with certainty that an 80% success rate is unheard of at any of these shops, in any markets, in any time frames. Which means that you have a talented cohort of traders! Thanks--


Alexandra said...

This is an awesome article. Now, let me ask a question that will instantly reveal that I am rather an inexperienced trader (or trader-to-be).
If the majority of the people lose money and know about others losing money, why do they keep trading?

Judging by this post, day trading does not appear to be a profitable activity.

Brett Steenbarger, Ph.D. said...

Hi Alexandra,

Not at all; I think your question is quite perceptive. Many people pursue trading for psychological needs; not necessarily because they are talented or skilled. I strongly suspect the percentage of people who make their living from trading on an ongoing basis is not so different from the percentage of people that make their living from sports, art, etc.


DmytrenkoAV said...

I saw many times situation. Traders lost own money, traders lost borrowed money and still trading in minus.. Even dont know on what they live :-)In this situation they dont see any possibilities to make things normal exept trading. Paradox

SnapTrader said...

Hi Brett,

Great post!

It brings up an interesting question. I understand how the losing traders worked out, but what about the winning traders. The article says: "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."

So, if even the winning traders lose money after transaction costs it implies that (at least as a group) there are no real winners. Did I read that right? I have to believe that there are SOME winners... maybe not. Perhaps we're all delusional... ;-)


Shirley said...

Hello Brett,

First, I want to say that I highly admire your understanding of the day trader's psyche, especially that price action of the stock market is an aggregate of the mass mindset of investors/traders, especially the large Institutional players, who move the market.

I have been in the preparatory stage for 8 months now as I ready myself to enter the real world of day trading, where in my prep stage, I have been 'paper' trading. I agree 100% about the "pattern recognition skills essential to day trading." In the 8 months I have created a 6 piece tool kit/6 prong strategy/gainful trade mindset approach, which works 80% with 'paper' trading. From my point of view, discerning intraday price direction is DOABLE.

Soon I will be real money day trading, anticipating to be in that small category of 10% to 20% successful day traders. I have also read that the success rate is 10%. The real success rate is fine either way, being that it is higher than the success rate for the artistic world of 4%.

Keep up the wonderful articles, which I enjoy reading whenever I come across them.


S Benard said...

My best friend and I have both been traders for several years. He continues to lose money year after year, but he keeps doing it. He has told me that he has lost about $250,000 in trading. I think that for him, it is an addiction -- a type of legal gambling. It was a factor in two divorces for him, also.

I've tried to teach him how I trade, but he won't listen. Instead, he keep buying automated "black box" systems that all lose money. Recently, he switched from trading futures to trading Forex.

Frankly, I wish I could convince him to give it up, but he just keeps trading and losing money.

Trader Kevin said...

Dr. Brett: "I've worked at quite a few prop firms and known and worked with many traders. I can say with certainty that an 80% success rate is unheard of at any of these shops, in any markets, in any time frames."

Ditto from my experience as both a floor trader and working in a prop shop. Most would-be traders are not successful.

Trader Kevin said...

S Bernard: "My best friend...has told me that he has lost about $250,000 in trading. I think that for him, it is an addiction--a type of legal gambling...I've tried to teach him how I trade, but he won't listen."

Everyone gets what they want out of the markets. Your friend has either inherited money and/or made money in order to be able to lose a quarter million. Why does he continue to punish himself? Does he feel undeserving of his wealth?

S Bernard: "Recently, he switched from trading futures to trading Forex."

I'm reminded of the guy who bet football with his bookie and lost every week. Then he lost money on the Super Bowl. His bookie said, "There aren't any more football games. Do you want to try hockey?" To which the bettor replied, "Are you kidding me? What do I know about hockey?"

S Bernard: "I wish I could convince him to give it up, but he just keeps trading and losing money."

How can the rest of us make money if you're out there convincing losers to quit the game???


Trader Kevin said...

Alexandra: "Judging by this post, day trading does not appear to be a profitable activity."

It's very similar to poker. There are a lot of small losers, some moderate winners, and a handful of huge winners. Meanwhile, the house gets their cut of every trade/hand.

There are several lures to trading. One is that it sucks working a regular job for someone else. Even if you have a backer your trading decisions are yours to own.

Also, some of us like getting up in the morning not knowing what the day will bring. Moreover, we love the intellectual challenge of the markets.

Finally, if you're a good trader you can make boatloads of money. You don't even have to be a big trader to start. The beauty of the markets is that they're scalable if you're in a deep, liquid market. If you can make money trading one or two emini S&Ps at a time, someone will give you money to trade 10, 50, 100 at a clip.

Alexandra, all the best to you in your trading career!

ROI2TCO said...

Winners are glorified and losers keep quiet. Anyone who are traded even for a brief period knows these statistics are true.

Look at number of people trying to recognize chart patterns and trying to find out the "holy-grail" pattern! How much money is poured into these so called "systems".

And you can add one more angle in your research - most people who make money are trading with other people's money, not their own!!

And yes it is analogous to poker. You have a $10,000 stack the person who is playing against you has $10 million. S/he is going ALL-IN every time. You may get lucky 1,2,3, ... 10 times, but all it takes to wipe you out is ONE turn.

Good post - sometime, you don't see what is right in front of you! And even if you do, you don't recognize it.