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Weekly Column

There's a Sucker Born Every 60,000 Milliseconds: Who Wins by Day-Trading Stocks? Not You

Status: [CLOSED]
By Robert X. Cringely
bob@cringely.com

With just a couple weeks to go before Y2K, I have the stock market on my mind. It seems to go higher every day, yet aren't investors worried about some horrific computer glitch that will kill their stocks? We already know I'm not too worried about the physical effects of Y2K, but this is a psychological effect. As the end of the year approaches, will people start to worry, maybe sell a few of those appreciated shares just in case? I hope not. This is one instance when I am absolutely in favor of market exuberance if it helps us drive the market straight through what I believe is an inevitable pocket of indecision, and on to new highs.

But there is much about the market that DOES bother me. I'm about to lapse into 1,500 words that many nerds will find of little interest to them because they won't appear to have much to do with technology. But those nerds would be wrong, because what I am writing about here involves the engine that drives their dreams, the money machine that makes their futures even possible. Technology is both enabling that future and endangering it at the same time. And I have no idea what to do about it.

A troubled gunman walks into a day-trading office in Atlanta and opens fire. Within a short time, he and nine others are dead. His wife and two children are found hours later, dead for more than a day. The gunman is a failed day trader of stocks. Why does this sad story get the attention of a columnist who specializes in high technology? Because it has more to do with technology — and in more ways — than most people realize.

Here's the dream. You start with a few thousand dollars and an online brokerage account. Using time-tested techniques learned at that day- trading class taught last weekend at the Holiday Inn, you quickly ratchet up your net worth through a series of lightning trades backed by low- interest margin loans. All it takes is an eighth-of-a-point change to make money. It doesn't matter whether stocks go up or down: Your time-tested techniques have you prepared. And you sleep well at night, because you never hold shares after the market closes: Everything is sold, and the funds are shoveled overnight into a money-market fund. You quit your job, move to the tropics, and let your PC continue to make millions while you play golf.

Is this scenario too good to be true? Yes, it is too good to be true. For most people who try day trading, it is a lie. There are day traders who make money, but most do not. Some of the lucky winners are riding a bull market, some are savvy investors who work very hard to understand the market, and some rely on the most powerful and sophisticated computer trading programs ever written — programs you'll never find for sale at the Holiday Inn.

Reality for most day traders says they don't make any money at all. A recent study of retail day traders by the North American Security Administrators Association found that only 11.5 percent of them do it profitably and with an acceptably low "chance of ruin," as the study picturesquely says. Seventy percent of day traders, according to this study, are so bad that they are likely not just to lose money, but to lose all of their money.

What kind of person enters a business where the likelihood of failure is 88.5 percent? Internet start-up companies have even worse records of success, but Internet entrepreneurs rarely invest much of their own money, and they are almost instantly employable even after their businesses fail. Who wants to hire a failed day trader?

The comparison with Internet start-ups is an apt one, because more than 80 percent of day-trading volume appears to be in the shares of Internet companies. Consider that the next time your Internet stocks seem to be whipsawing for no very good reason — and the next time Internet stocks are adding a troubling volatility to the markets as a whole.

Day trading has been around as long as stocks have been bought and sold, but until recently, nearly all of it was done by institutional investors with access to faster information and lower sales commissions than you or I could get. The rise of the Internet and online brokerages has removed much of that price and information advantage, and now — at least theoretically — home investors ought to be able to be as effective as their institutional competitors.

But can you really program a computer to find patterns in stock prices? Yes, you can, according to Jim Hall, who did just that. Hall was an engineer at Deere & Co. in Moline, Illinois, who was asked to build a combine that didn't need a driver. Deere was worried about the rising cost of farm labor, and so asked Hall for a machine that didn't require skilled labor — a machine that would automatically learn the field and harvest without supervision. Hall built the combine, which was never marketed, then converted the software to learn another field — the stock market. Hall became the manager of Deere's pension portfolio, successfully harvesting capital gains instead of wheat.

"We learned there are periods when the market does have patterns," says Hall. "There are windows of predictability. We also found it is easier to learn when to get into the market than when to get out."

Don't expect to find Hall's software for sale at CompUSA. "Nobody is in the business of giving money away," he says. "If you have a tool that works, you don't share it. The advantages gained are short enough as it is. As soon as the pattern becomes obvious, it gets arbitraged away." Knowing this, why would anyone offer courses in day trading? If the teacher was a good day trader in his own right, he would be much wiser to play the market and forget about sharing his wisdom. So most teachers of day-trading courses probably don't have much wisdom to share. And those who do must have another motive.

"Some of those courses are taught by the day-trading companies themselves," explains Andrew Lo, professor of finance and director of the Laboratory for Financial Engineering at MIT's Sloan School of Management. "It brings in more customers and builds trading volume." Trading is not investing. The difference is critical and involves much more than the duration of each stock position. Investing is a bet that a company or industry will improve its profitability or market share over time. Trading is a bet the stock will rise or fall in the next 10 minutes or hour. Investments can lead to real gains for all shareholders as the market rises, while trades require someone to lose a dollar for every dollar you gain. If 88.5 percent of retail day traders are losing money, who is making all that money? The institutional day traders are making it.

"All that money lost by amateur day traders is probably going as profits to professional traders at Goldman Sachs or Morgan Stanley," says Lo. "Somebody has to be making it."

Day traders at Goldman Sachs, to use just a single example, aren't chosen at random. The firm doesn't put billions in the hands of traders who aren't likely to succeed. There is first a process of training and then a process of winnowing. And unlike you and me sitting in our boxer shorts at our trusty PCs, those Goldman boys and girls have entire departments of rocket scientists with supercomputers revving behind them. These professionals aren't infallible, but they have a clear advantage over those of us at home squinting at our E*Trade screens.

This is why the National Association of Securities Dealers is considering tightening qualifications and margin rules for day traders, hoping to at least slow the bloodbath before the Securities and Exchange Commission becomes involved. The Feds are beginning to view day trading like gambling, and probably for good reason.

An old bookie once told me that 85 percent of horse players lose money, 10 percent break even, and 5 percent win on a long-term basis. These numbers aren't all that different from the day-trading figures cited above.

"They are very similar skills," says Lo. "Professional gamblers and day traders require the same kind of discipline. They work hard to understand both the game and their opponents and make it their business to win. It's not easy for them, and it isn't a game. Someone who makes a living playing poker could become a successful day trader in a few months, while most of the rest of us could never make it."

If day trading has any benefit for the rest of us, it's because the house — our new-as-pennies online brokers — always wins. Day trading builds sales volumes that encourage the growth of discount brokers. It effectively subsidizes better and quicker stock information and cheaper trades for us all. If you aren't a day trader, but an actual online investor, you might well say hurray for the day traders.

But there is a cost, too — not just in wrecked lives and shattered egos, but in market fragility and volatility. If the Internet really is the Next Big Thing — and I believe it is — that future won't be built on day trading, which is, after all, a game that zeros out at the end of every day.

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