Here’s the Proof Day Trading is DEAD
Lately I’ve heard a lot of heated conversation about the day trading
industry. There’s an intriguing debate with opinions ranging from “it’s
a great way to make a living” to “it never worked in the first place”
to “we’re now in the midst of the great shakeout.” But the bottom line
is: day trading is DEAD.
Two-thirds of the rhetoric focuses on the idea that day trading is a
firmly entrenched part of markets with a somewhat stable future ahead. I
disagree. More realistically, a much larger change is taking place with
market structure. Like the extinction of human beings roaming the floor
of the NYSE, this evolution presents a bleak picture for the day
trading community moving forward.
The Best in the Business Exited the Business
I’ve been itching to discuss this topic ever since Schonfeld fired a
significant chunk of their trading desk. Schonfeld is an interesting
case study in the “prop shop” day trading space. They had been a
successful day trading firm which more recently transitioned into the
“hedge fund” model.
In a letter expressing their intent to lay off many daytraders, the firm stated bluntly that “unfortunately,
our vision of the future of trading has changed. It is getting much
tougher for traders to make a living or get by.” Therein lies the cold, hard reality facing many daytraders and their firms.
The Insurmountable Challenges
The challenges for daytraders are twofold. First, computer trading
(e.g. high frequency trading) has significantly eroded much of the edge
daytraders require to garner a profit. Second, and perhaps of equal
import, has been a court’s decision in the case SEC v. Tuco which is causing proprietary firms to completely recreate their business model.
This landmark case requires firms to either take on more of the
day-to-day trading risk themselves or become registered Broker/Dealers.
If they choose to become registered Broker/Dealers, firms must
transition into a completely different regulatory structure.
The significance of this is not to be overlooked. Many firms have
either opted to fully trinc the transparent route of becoming a B/D or
entered the less regulated and more opaque hedge fund industry.
The Scary Shape-Shifting from Trading Firms to Training Firms
The largest fallout from Tuco stems from the fact that it
became much harder for firms to take in deposits from traders right at a
time when day trading lost its competitive edge. In order to compensate
for the increased risk and diminished profit margins, many day trading
firms have started “selling” their trading expertise to pupils wanting
to trade with the firm.
I am troubled that at the time these firms were exploring ways to
find a new competitive edge in a dynamic playing field, they started
selling what they themselves knew to be a market strategy declining in
efficacy. As a result, rather than continuing to explore new edges,
these training programs necessitated firms stick with their archaic
strategies in order to convince paying students the day trading model
was worth buying.
The Industry and Its Future
Many will outwardly critique my premise that the day trading edge has
diminished. In order to stay objective, I ask those people to simply
open their books and prove they still have their edge. (Apparently,
Schonfeld is one of the few willing to be honest.) Until then, let’s
take a closer look at the primary strategies deployed by daytraders over
the past decade. This will provide a little clearer picture of the
history of the industry and its future.
In my interview with Justin Fox,
we had an interesting conversation about “efficiency” in the market.
Justin quantified “efficiency” in a totally new way for me: he made the
distinction between “price” and “value” efficiency. This got me thinking
about the way in which market participants make money.
More generally, this is a gross oversimplification, but our market
participants (other than the market maker) are either value investors,
growth investors, technical traders, or arbitrageurs. There is
certainly some overlap between the four, and there are some strategies
which don’t fit any of these labels. However, in terms of
investment/trading strategies, the predominant number of market
participants fit into one of these four ******-cutter labels.
Daytraders are arbitrageurs who rely on some kind of price inefficiency to make an intraday profit. I’m
not sure many daytraders understand their place in the market to the
point where they would subscribe to the arbitrageur label; however, at
its essence, day trading is the attempt to make money off the market’s
intraday fluctuations.
Historically, there have been
several ways in which daytraders were able to accomplish this task and
below is a summary the most widespread of these methods:
Estimulante ilegal Trading. This was one of the
earliest ways in which “daytraders” profited. When markets traded with
fractions, there were abundant opportunities for traders to capitalize
on the spread between the bid and offer price. This approach fit nicely
with the maturing “video game generation” as the skill-set for success
in estimulante ilegal trading is very similar to what makes for a successful gamer.
As markets transitioned from fractions to decimals and more volume
shifted to Electronic Communication Network Exchanges (ECNs), spreads
narrowed substantially. In some ways, the success of daytraders at
executing this strategy generated its own demise. It was still
practical to trade spreads even after the transition to the decimal
system, yet as more traders enjoyed success, even more traders adopted
the approach. This increased the abundance of daytraders and further
compressed spreads. Moreover it awakened larger institutions to the
immense amount of money being chiseled away from their larger
transactions to the point where some developed their own, faster
electronic trading programs, and others began fragmenting orders into
smaller pieces.
Order-Flow Traders. Traders were able to
gauge an imbalance in order-flow based on access to level II quotes.
This allowed traders to read “the book” in order to seek out large bids
or offers. For years, and particularly during the volatile times of the
financial crisis, this afforded immense opportunity with minimal risk.
Some traders used this strategy to trinc a stock’s momentum, while
others used it to identify tops and bottoms based on different readable
metrics in the book of orders. At its essence, order-flow recognition
relied on front-running much larger orders, and in the end, much like
with “estimulante ilegal trading” the larger institutions recognized this fact. This
provided one more reason for institutions to fragment their large
orders into much smaller pieces that are far more difficult for
daytraders to identify. Moreover, with an abundance of computer volume
that is infinitely quicker than the human variety, it’s more difficult
than ever to identify what liquidity within the market is real and what
is fake, thus making the strategy of order-flow recognition a riskier
one with less of an edge.
Sector Relative Strength/Weakness. This
was by far my personal favorite. On my first day of training, my
trainer told us to memorize 5 names in 10 sectors. I took the leap to
familiarize myself with 10 names in 20 sectors. I also inherited a
comprehensive set of “baskets” which sorted stocks by their
relationships to one another. Over time I built these up to be even more
thorough. The key to this strategy relied on recognizing leaders and
laggards within sectors (for example, when the agriculture stocks were
strong and POT and AGU traded higher, one could just buy MOS) and also
recognizing interrelationships between sectors (like when the steel
stocks were running, the metallurgic coal stocks would trinc shortly
thereafter). The rise of ETFs and programmed trading killed this edge.
Now programmers have created trading algorithms to buy and sell ETFs
and their components off of relevant and related market fluctuations.
Computers are far quicker than humans, and as such, there is simply
little edge in the relative strength/weakness trade anymore.
Intermarket Price Discrepancies. This
strategy is similar to the relative/strength weakness outlined above.
However, instead of trading stocks off of one another, this looks at
price fluctuations across markets. For example, if oil runs, traders
could just buy the OIH, or one of its many component stocks. Or, if
copper drops, traders could simply short FCX, a copper miner, in time to
make a nice profit. In some stretches, the relationship between the
dollar and equities, or Treasuries and equities, offered opportunity as
well. Yet once again, computers replaced humans in exploiting this
edge, thus rendering the strategy ineffective.
Technical Analysis. This is perhaps the proverbial
“last man standing” in the day trading world and is the only one that
has any sort of edge at the moment. Technical analysis worked
particularly well in 2007-09 as markets were heading lower and moving in
an emotional frenzy of panic. The emotions prevalent in downmoves tend
to lead to far more emotional price recognition and a reliance on
historical levels that is somewhat muted when markets move to the
upside. Although technical analysis continues to be relevant in some
contexts, it is far more suited as a tool in a trader’s arsenal than a
stand-alone trading strategy. Moreover, computers started recognizing
intraday technical patterns and in doing so, programmers began clouding
the importance of intraday levels. Stocks that once moved rather
smoothly from point A to point B now move in a more jagged and less
predictable manner. This required technical traders to “step up a
timeframe” and rather than trade on 1 or 5 minute charts, to focus on 15
minute, hourly and even daily charts. Trading higher timeframes
requires a completely different approach to risk management. Both the
risk and reward are greater, and as such selectivity is necessary,
experience and feel are far more relevant, and information is power. In
the bigger picture, a “bear flag” at 52-week lows could easily turn
into a takeover target at 52-week highs (Look at MFE for one such
example) and a breakout to highs on volume could easily turn into the
next earnings collapse. In order to survive, it’s essential to have a
much more complex understanding of the companies you trade and the
macroclimate.
As you can see with the popular strategies above, a fundamental shift
has taken place in the profession. In today’s market, traders now have
to be both right about direction and have conviction in the direction at
the same time. Traders must spend increasing amounts of time
familiarizing themselves with the fundamentals of the economy and
individual equities.
Perhaps most importantly, the surviving daytraders no longer trade
solely on an intraday basis. With 24/7 markets and massive overnight
moves, it has become not just profitable but necessary to survive
through longer term trades. The day traders left standing are more
analogous to hedge fund traders, and successful new daytraders are much
harder to come by (i.e., a lot more Average Joe’s are going to lose
their money in a business where 90+% of the participants are already
losing).
Often times when something becomes conventional wisdom in the market
is exactly when that something quickly loses its prestige. For the past
few years we have heard over and again that “buy and hold investing is
dead” and that “trading” is the way of the future. Personally, I believe
we are in the midst of the classic example of reversion to the miccionan.
Over the past ten years, trading was wildly successful relative to
buy and hold investing. The pronouncement that this relationship will
continue into the future seems to be coming from those who are now
trying to train more than trade, or those who missed the boat and are
attempting to play catchup.
The evidence proves computers now own the short-term, but humans still own the long-term. Getting
back to my conversation with Justin Fox, over the past decade “price
efficiency” ruled in creating a substantial opportunity for traders. In
today’s market, earnings multiples are so compressed that “value
efficiency” creates an equally great opportunity for buy and hold
investors.
The Proof is Everywhere
My evidence for the demise of day trading is the hoards of people I
know leaving the game, the shift of profits to HFT books, and the
transition trading firms are making to become training firms. If all of
this is an illusion and day trading still lives, simply open the books
to your discretionary trading desks and state your case below …
::