Friday, August 15, 2014

Tomatoes and Fruit Salads: What Predicts Day Trading Success

Does day trading skill really exist?  The recent post took a research-based look and found evidence both for the existence of day trading skill and for its rarity. 

What might account for day trading success and failure?  Another valuable study was conducted in the Korean futures market, with the Kospi index.  Ryu studied the day trading results for the Kospi over a more than three year period.  He found that 91% of the day traders were domestic individuals and these traders accounted for over 85% of all transactions.  Foreign institutional day traders and domestic institutional day traders made up most of the remainder of the activity.  On average, these institutional day traders traded much more frequently--with much larger average volume--than the domestic individuals.

Ryu found that the domestic individual traders lost significant money on average.  He refers to them as "uninformed and noisy".  Conversely, the institutional day traders made money on average.  Perhaps most interestingly, domestic individual traders who traded more lost more money; they seemed to be overconfident.  Foreign institutional day traders who traded more made more money.  They seemed to be exploiting a genuine edge.  Ryu surmises that:

"This implies that foreign day traders and money managers are generally better equipped in terms of their wealth, sophistication, specialty, and trading experience than ordinary day traders." p. 9.

What does this mean?  Perhaps this:

Resources make a difference.

Knowledge matters.

Experience counts.

Most of all, wisdom is crucial:  the ability to act on the awareness that sometimes, the edge conferred by knowledge and experience simply isn't there.  There's no edge to putting a tomato in a fruit salad.

Consider this example of successful day trading from someone I knew years ago:  He cultivated relationships with the sell side and had access to the major forecasts for earnings releases for companies.  He also polled money managers and equity sales professionals quarterly.  This told him the "true consensus" for each release.  He tested which earnings releases were movers of stocks based upon several factors, including deviations from consensus.  Some deviations were worth trading on a same day basis; others provided a longer-term edge.  For the day trades, he and his team developed a rapid execution algorithm that entered orders into various stocks as soon as releases came out and deviations from consensus could be calculated.  Those trades were always closed out by end of day.

He was a successful day trader.  He had specialized knowledge and a clearly defined edge.  He also had the wisdom to make bets only when the consensus was off sides and all other factors lined up in his favor.  Many days he did not trade.  That alignment of knowledge and wisdom was the best predictor of his profitability.

Success is possible in trading, but not, as Ryu notes, to the uninformed and overconfident.

Further Reading:  Tackling the Challenge of Day Trading