Project Nayuki

So you want to be a day trader? Bad idea.

I’ve met a number of people who think if they put their mind to it, they can start trading stocks in their spare time and make some money from it. They see benefits like being able to work comfortably from home using only a computer and Internet connection, not needing years of schooling in difficult subjects, and possibly making as much money as a typical full-time job. It’s true that any individual can easily sign up for a trading account and take a shot at earning money, so why not try it?

Now if this is what you think, then I have bad news for you. From my own reading and investment experience, I assure that the odds of success are stacked heavily against you. The system is practically set up to encourage you to gamble and lose money, and you’d be a fool to ignore the warnings and continue on.

(Note that by “day trading”, I mean the frequent buying and selling of securities and financial instruments such as stocks, bonds, options, futures, treasury bills, foreign currencies, etc. to be held for a short period of time like hours, days, or weeks. This contrasts with long-term investment over a period of years and even decades.)

Why you can’t be an effective trader

Of course it’s not hard to be merely a trader. But I argue that it is hard to start from no experience and become an effective trader, which means earning money consistently in the long run. To set a concrete reference point, let’s assume the goal is to gain 20 000 USD per year when engaged in trading for at least 1 year. (The amount is comparable to a full-time minimum-wage job, and the time period is intended to reduce the effects of luck.)

Firstly, day trading implies interacting in the field of finance. This is a technical field that has its own set of terminology and concepts, and also requires modest mathematical skills. Just like how you cannot be a doctor without knowing medical terms and concepts, you can’t be an effective trader without understanding the concepts behind what you are doing. For example if you are buying a bond, you should understand that at the basic level it represents a piece of debt with a fixed payment schedule. Digging deeper, you should understand bond concepts like coupon, yield, face value, credit rating, default, and so on. Learning these financial concepts[0] is non-trivial because there are many of them, and some can have long explanations and subtle catches. If you think you can start trading without understanding these, you are already setting yourself up for failure. But if you can overcome at least this hurdle, then good for you – you are now able to understand what’s going on and be able to think things through (instead of blindly playing with numbers and money).

Public news is worthless for making effective trade decisions. The efficient-market hypothesis is a widely held belief that states that the price of a security (stock, bond, etc.) already reflects all the public information known about it. For example, if an oil company just discovered new resources (which is considered a good thing), then its price will rise – but in reality, its price will have already risen by the time the news article reaches you, which means you would be too late to profit from the news. To consistently beat other traders/investors in the market, you need to have exclusive information – faster or better in quality – that they don’t have. Since public news is out of the question, this implies one of two things: you either need private information from the company in question (which is generally illegal – see insider trading and generally confidential proprietary information), or you need to guess and make up information from thin air (and your guess needs to be better than your competitor’s guesses). As you can see, all 3 sources of information – public news, insider information, and guessing – have serious drawbacks; as a result, you are unlikely to make effective trades solely based on information.

Market timing doesn’t work, and expert forecasts are unhelpful. As a corollary to the EMH, it means stock prices are always correct and fair, every day, every minute. If you buy something because you expect its price to go up in the future, it would be a mistake to attribute your expectation to intuition or common sense – your expectation is based on mere belief, because anything that is a fact is already reflected in the security price. Even if your beliefs are right sometimes, they can be wrong just as often (related to “confirmation bias” in the next paragraph). As a side note not strictly related to trading, this means you should buy/sell things because you need them, not because you expect prices to change – for example, if you need to buy US dollars for a trip to the US, then do it near the date of travel rather than far in advance, because you have no power to predict whether the exchange rate will go up or down. Now, not only are your own beliefs unreliable, but even forecasts made by financial/economic/business experts (as you would see on TV business news) are unreliable. Yes, these experts can tell an accurate picture of the economy as a whole – such as the GDP growing by 1%, or a trend towards buying gold – but their statements are worthless for the sake of trading. These forecasts are a mixture of public news and mere guessing, which is not information that you can profit from. They also have a tendency to contain vague qualitative statements that can’t even be judged true or false after the fact – e.g. “Europe as a whole could face a severe recession next year and have consequences for the rest of world”; how do you even interpret that rigorously?

Irrational behaviors and cognitive biases cost you real money. These flaws in human reasoning are studied academically in fields like economics, game theory, and psychology, but when you make financial decisions according to a false interpretation of reality, you will end up with money-losing consequences (with high probability). People acquire essentially all of these biases by nature; it takes conscious effort to recognize them and mentally train against them. Here’s a bunch of cognitive biases – I include a brief explanation/example, and you can read more on Wikipedia or by searching the web:

  • Greed (aiming for the best rather than for satisfactory)
  • Hubris (overconfidence from a streak of success)
  • Hindsight bias (it’s easy to find a price peak or trough in retrospect; it’s easy to expect a rising trend to continue)
  • Gambler’s fallacy (a losing streak does not imply a win is imminent)
  • Self-serving bias (good things are due to you, bad things are due to factors outside your control)
  • Confirmation bias (ignoring evidence that contradicts your beliefs)
  • Survivorship bias (every current mutual fund can be a winner – if all the losers were closed in the past)
  • Mental accounting (treating different bundles of money as non-interchangeable)
  • Anchoring effect (basing decisions on irrelevant past information)
  • Sunk costs (avoiding abandoning a partially complete task where much cost has already been paid)
  • Loss aversion (treating a loss as being worse than a gain of the same magnitude)
  • Endowment effect (not wanting to let go of something you own)
  • Psychological pricing (investors might deem that 1000 USD per share is a magical threshold for GOOG)

These irrational behaviors take a bit of reading and serious thinking to understand, but truly recognizing them in real life is much harder than it sounds. When learning about these behaviors, the examples are purposely contrived and quite clear-cut. In reality when you’re trading, the situation is ambiguous and the information incomplete, and it’s hard to recognize personal biases and irrational behavior on the spot. (It’s a bit easier to recognize them in hindsight, but by then it’s too late.) After seeing this partial list of human cognitive flaws, it’s not hard to conclude that as a trader, your worst enemy is yourself – namely the fact that your intuitions and instincts deceive you into making illogical, bad choices.[1]

Institutional investors are big, powerful players in the financial markets. For example, these are organizations that control a mutual fund, pension fund, hedge fund, university endowment fund, etc., each with assets in the billions of dollars. When institutional investors make investment decisions, they do it with expertise and influence. They employ professionals who are trained in finance and have experience working in the field; they employ people whose job is to monitor prices, analyze trends, and find non-obvious facts about the world. Because of their large size, they can negotiate discounts and special deals with sellers; moreover, they can buy smaller companies outright and revamp their management for better profitability. You, as an individual investor, have none of these advantages.

In addition to humans, computer programs also participate in trading. Modern computers are spectacularly cheap and powerful, and a single computer can easily do a billion calculations per second[2]. A program running on a computer can analyze millions of data points in thousands of stocks a second, and have sophisticated algorithms to find patterns, all backed by knowledge from decades of academic and corporate research. Moreover, these programs can react to fluctuating prices, incoming orders, and financial news on a millisecond-by-millisecond basis.[3] The people who write these programs are well-versed in finance and computer science/programming, and they are highly paid for this work. I know this almost firsthand because my friends and I have been contacted by recruiters from such algorithmic trading companies, and we’ve seen typical salaries for these positions in the neighborhood of 100 000 USD per year. Now, coming back to you – as a human trader who has a limited capacity to read, analyze, and remember information, and has a reaction time measured in seconds or minutes, how can your level of speed and expertise possibly compete against god-like algorithms designed by incredibly smart specialists?

To hit the point home, here’s a real scenario: Suppose we’re talking about foreign currency exchange, and you want to find arbitrage opportunities. Let’s say that 1 CAD = 0.9721 USD, 1 USD = 0.6879 EUR, and 1 CAD = 0.6513 EUR. Did you notice that if you convert CAD to USD to EUR, you get 1 CAD ≅ 0.6687 EUR, which is a better rate than the direct conversion? Okay, maybe that was too easy, maybe that only took a few seconds on your pocket calculator. But a computer would have already beaten you to the discovery – if we’re looking at conversion chains of length 2, then a computer will have found this arbitrage in literally microseconds. To make things worse for your hand calculation, the world has about a hundred currencies, and you will need to explore arbitrages that have a path longer than length 2, both making your task immensely more difficult.

The world has plenty of businesspeople who profit from your ignorance and gullibility. Whether it’s selling you a lemon (defective car) or signing you onto a cell phone contract with surprisingly high fees, the field of finance has its predators too. There are people, companies, infomercials, and websites that will show you large amounts of praise for a single concept like penny stocks, dividend aristocrat stocks, gold bullion, hidden secrets in the energy sector, speculative bonds, complicated derivatives, subtle forms of tax evasion, special real estate, you name it. For the most part, you can assume these schemes are ineffective, illegal, or both. If it sounds too good to be true, then it is too good to be true. Another example, more modestly, is a salesman who persuades you to buy a venture fund and touts the benefits but fails to inform you that it is a high-risk investment, when you were hoping to invest in a more stable fund. In general, as a newbie trader you are most vulnerable to falling for one of these schemes/scams, because you want to take action but you don’t have a refined sense of right and wrong. When in doubt, ignore the solicitations and keep your money to yourself.

The more often you trade, the more your brokerage wins. Individual retail traders like you and I have to go through a broker, and the broker charges commission fees for each completed trade (usually in the range of 10 USD). Whether you’re making money or losing money on a trade, you still have to pay the commission cost, making your broker richer no matter what. This would explain why brokerage firms offer free resources to encourage you to trade more – things such as tutorials on investing, market news, and historical price data. There are also securities/products that have no direct commission fee, such as foreign currency exchange and over-the-counter fixed income products (bonds, GICs, etc.). However in these cases, the transaction fees are embedded within the bid-ask spread of the prices.

If after reading my arguments you still think you can succeed, you can go try a stock simulator game. There you will get to learn firsthand what it’s like to trade stocks, as well as all the activities that accompany it: figuring out how to do market research, deciding when the price is right, spending time checking your stocks every day or every hour, reading company reports, etc. Hopefully you will discover that your decisions are right about as often as they are wrong, that you can’t ensure that you make a profit, and that checking prices and researching news/companies requires a lot of time and skill.

Instead, be a responsible investor

If I’ve managed to completely scare you from any form of trading or investing at all, then that’s not too bad. Investing is full of traps, and it’s better to be safe than sorry. (Short advice: If you don’t know what you’re doing, then just put your money into a savings account. It’s hard to screw this up. If however you’re hungry for more returns, then read on.)

In light of all the negative points expounded above, what can you do as an individual investor?

  • Understand the balance between risk and reward. If you want more returns from investment, you need to take on more risk. Consciously choose a level of risk that is acceptable to you, and stick to your plan.

  • Understand what you’re putting money into, both the company and the product. If you have no clue about where the revenue of company FooBar comes from, or what it means to sell futures contracts, then don’t invest in it. And don’t play with options trading unless you understand the calculus and differential equations behind the Black–Scholes model.

  • Understand the costs of investing – brokerage commission fees, account fees, fund management fees, front/back-end loads, tax rates and categories, etc.

  • Diversify your holdings to reduce risk and protect against volatility. Favor buying index funds (especially ETFs) instead of the stocks and bonds of individual companies.

  • Invest for the long run. In a world dominated by breaking news and fast algo-trading, it is still a valid strategy to buy reasonable companies/bonds, hold them for years without trading them, and let the profits roll in. Note that this is a legitimate “get rich slowly” scheme, where “slowly” means 5 to 50 years.

  • Don’t panic when the markets crash. Don’t even check your stock prices every day – why put yourself through the emotional burden of continually doubting your choices? Checking once per quarter should be more than enough.[4]

  • Finally, invest in yourself – specifically your special skills. If you have a passion for art, spend more time making things. If you’re a scientist, do more exploration. If you run a business, figure out the next step for improvement. Don’t worry too much about financial investment, because it’s probably not your occupation. Do what you’re good at, and bring value to the world.

Notes

More info