Thursday, April 1, 1999
WANTED: Savvy, computer-literate risk-takers. JOB: Trade stocks day in and day out like a big shot trader. BENEFITS: Flexible hours; potential to make lots of $$$. DRESS CODE: PJs.
Traditional investors have been following the “buy low, sell high” logic for years, and all investment gurus trumpet the wisdom of a “buy and hold” strategy for investments in stocks. “Day traders” turn this advice on its side, taking it to the limit. Not only do they buy low and sell high when the market is on the upswing, but they also sell high and buy low when there is a pronounced downturn by selling stocks that are hit “short.” They do this “round-tripping” several times in a day. The only investment criterion they look for is momentum in the price of a stock; day traders thrive on volatility. The ultimate kicker is that most day traders hold on to their positions for less than a few hours, if that. Most are happy to make their profit and run. Since day traders typically do not hold positions overnight, they do not have to worry about settlement and exchange of monies. This puts the IRS’s views on long-term capital gains and short-term gains in a new perspective.
Wake Up and Smell the Money!
Recently, the Securities and Exchange Commission has taken a renewed interest in the day trading craze that is sweeping the nation. Newspapers and magazines are replete with articles glorifying day traders who quit successful careers and made thousands of dollars from their own homes and increased their income by orders of magnitude.” They are often heralded as modern day Robin Hoods who steal from the “powerful” brokerage companies and their professional traders (the market makers).
Proponents of day trading argue that this activity increases liquidity in the market and also narrows the spread that the market makers enjoy. Liquidity is defined as the existence of buyers and sellers at all times and the availability of a lot of shares in the market at all times. “Spread” is the difference between the bid price and the ask price the market makers quote on, say, NASDAQ.
After the stock market crash of 1987, many individual investors complained that they did not have access to the markets during the plunge, as market makers did not pick up their phones. Fearing regulatory intervention, the industry’s self-governing body, the National Association of Securities Dealers (NASD), proposed the SOES (Small Order Execution System) solution. This system provides small, individual investors direct access to the inside market (the best bid / offer advertised on the NASDAQ system by the market makers). The NASD held that all its member firms would be obliged to execute orders that come in through SOES at the inside market price; the SOES limit was set at 1000 shares or less. The SEC, the regulatory body appointed by the government to oversee the industry, backed this plan and encouraged the listed exchanges to come up with similar systems to boost the confidence of small individual investors. Thus, the SOES (for the NASDAQ-listed stocks) and SuperDot (for NYSE-listed stocks) were born. These systems enable market makers and specialists to execute orders that come to them via these channels on an automated basis.
Lets Play the Market
There are three major factors that have contributed to the existence and growth of the day trading “industry.”
The first—and probably the unlikeliest—catalyst in the emergence of this new paradigm in investing is the SEC and the NASD. By creating the SOES and the SuperDot mechanisms, they inadvertently opened the doors for thousands of professional traders or “SOES bandits.” In fact, day traders took full advantage of these new mechanisms and have prospered under the guise of the small investor. Day traders’ motives are in fact quite contrary to those of traditional small investors who buy and hold stocks of “good companies” to pass to their heirs.
Secondly, the emergence of Internet technology enables individual investors to get current market prices, news and analysis on a real-time basis in any corner of the country. Before the proliferation of home computers, accessing prices and other market information was difficult; now, however, there are a number of Web sites and online brokerage services that offer this information at little or no cost.
Thirdly, the past few years have seen a great deal of automation in the securities processing industry. Billions of dollars spent on IT in the back offices of the brokerage houses have helped bring down the cost of processing securities transactions. There was a time when individual investors had to pay hefty fees for investing in the markets. Full-service brokers would charge investors a premium for sharing closely held market information, available to the select few who worked on the street. Also, the fees factored in costs associated with clearance and settlement of securities, which was a highly labor-intensive process.
Risk What’s Disposable
Day traders take full advantage of the regulatory environment, the availability of information online and the low cost of trading to make multiple trades each day, buying and selling stocks about which they may have little knowledge. In an interview with the Washington Post on Jan. 28, SEC Chairman Arthur Levitt said that “strategies such as day trading can be highly risky, and retail investors engaging in such activities should do so with funds they can afford to lose.” He added, “I am very concerned when I hear of stories of student loan money, second mortgages or retirement funds being used to engage in this type of activity. Investment should be for the long run, not for minutes or hours.”
In all kinds of trading, investors should adhere to three “golden rules,” Levitt advised: Know what you are buying; know the ground rules under which you buy or sell a stock or bond; and know the level of risk you’re exposing yourself to. He warned investors to expect delays in electronic trading systems and to realize that “just because you see a price on your computer screen doesn’t mean that you will always be able to get that price in a rapidly changing market.”
Tell that to the thousands of day traders whose morning coffee smells like dollar bills and the modem flickers all day.
