Day gamblers on a losing bet

The more one examines the day trading phenomenon, the more bizarre and disturbing it becomes. Returning from a visit to the United States, where the phenomenon remains more extensive than I hope it ever becomes here, it is clear how dangerous and illogical the whole business is, especially when undertaken by those who do not realise what they are doing, as often seems to be the case.

The more one examines the day trading phenomenon, the more bizarre and disturbing it becomes. Returning from a visit to the United States, where the phenomenon remains more extensive than I hope it ever becomes here, it is clear how dangerous and illogical the whole business is, especially when undertaken by those who do not realise what they are doing, as often seems to be the case.

The problem with day trading is not just that there are so few properly documented examples of people who have made a decent profit from it. Such evidence there is points entirely in the other direction. We know from studies in the US by bodies such as the Securities and Exchange Commission that three out of four day traders lose money, a figure sure to be similar here when the sums are finally totted up.

More recently, you may have seen a report about a study by academics in California which confirmed the worrying fact that most day traders seriously overestimate how well they are doing. As I have mentioned here before, we are all prone to a string of psychological biases on the subject of money, of which self-delusion about our success is high on the list (especially, it seems, if you are male, as many day traders are).

Just as disturbing is the strong suspicion, which I don't think can be formally proved, that at least half of those who are engaged in day trading have no chance of making a decent return on their money. If you analysed what they are doing, and worked out the odds of success, you would find most are pursuing strategies from which it is simply impossible to make money over time.

There is nothing new about this phenomenon. It will be familiar to anyone who has studied the mathematics of backing horses or gambling at roulette. To understand why, you have to appreciate that if you are a genuine day trader opening and closing positions every day, you are effectively taking bets on a random series of events.

Whether you appreciate it or not, what you are engaged in, as the head of the giant online US broker Charles Schwab correctly observed at the weekend, is gambling, not investing. While there is a link between the current price and value of shares, I know of nobody who believes or claims that hour-by-hour intra-day movements in prices are anything other than dominated by short-term trading influences.

No professional trader would claim that you can make money by superior information or superior analysis over such a short time period. That is why all professional traders employ technical rather than fundamental analysis to guide them in the formulation of successful trading strategies.

They mostly make their money by tracking the behaviour of recent prices, looking for overbought or oversold situations, rather than from looking at the inherent value of what you are trading. That is what day trading is about.

Once you accept you are gambling, the next step any professional will do is work out (1) the costs of playing the game; and (2) the odds of coming out ahead if you do play. The next big problem with day trading is that the costs of playing the game are far from insignificant.

First, there are the explicit transaction costs, such as broking commissions and stamp duty. These can easily absorb 1 to 2 per cent of your money, even if you deal at the low prices on the Net. Next, you have to add the hidden costs of trading - the spread between bid and offer prices every time you buy or sell, the cost of your internet access and the annual cost of any software and information services you buy.

Finally, if you want to do the sums correctly, you have to add in the opportunity costs of spending all day sitting in front of your PC. There is the cost of the money you could have made by doing something else with your time; and the cost of the interest or growth you could make by putting the money you have tied up in your trading activities to more profitable use. (If you are retired and looking for a hobby to while away the hours, you may be exempt from the time-foregone calculation).

Throw all these numbers together, and simple maths will show an estimate of the kind of returns you will need to give yourself a chance of coming out ahead over time. Bear in mind that if you are investing in the stock market, the true benchmark you should be using is not the absolute sums you make, but how much you could have made by leaving your money in a low-cost index fund instead.

Clearly, the sums will vary from individual to individual. But whichever way you do them, the vast majority of day traders would be well advised to be doing something else. This is especially true in today's volatile markets, with daily movements of more than 3 per cent commonplace on the Nasdaq market, as the graphic shows.

Yet all the evidence I have seen suggests most of those engaged in day trading do not even begin to appreciate what they are playing at. They think they are investing when they are gambling. They think better information is going to give them a winning edge over time.

They are not accounting for their results in the right way, and they have no training in the basic skills of money management that you need if you are to survive in the trading game (even the mighty brains at Long Term Capital Management, with two Nobel professors on board and huge computing power to provide their risk-management systems, failed to get this part right).

Perhaps most day traders are destined to lose money from the moment they switch on and log into their chatrooms. In no way do I imply moral disapproval of what day traders are doing. It is a free country, and speculators fulfil a useful market function for the rest of us. My objection is simply that it is a dumb thing for most people to do.

davisbiz@aol.com