The lure of quick profits from skyrocketing tech stocks was too much for Isaac Belbel and John L. Powell. The two friends, one an ex-broker and the other a former restaurant owner, spent the last year in front of computers in Watertown, Mass., at a branch office of All-Tech Investment Group Inc. They were executing rapid-fire trades on a daily basis in companies such as Dell Computer, Amazon.com, and K-tel. Their goal: to make money on small price swings in these volatile stocks.
But the duo's stock market thrill ride ended in disaster. They lost at least $200,000 trading for themselves and five friends, say Massachusetts securities regulators. On Dec. 10, Massachusetts regulators charged Belbel and Powell with trading without a license--regulators said they needed it because the two men were trading for others. Regulators also threw the book at All-Tech for numerous securities violations, including fraud. "All-Tech's Watertown office was a vipers' nest," complains Mathew J. Nestor, chief of enforcement for the Massachusetts Securities Div. Belbel declined to return phone calls. And both Powell's attorney, William Bulger Jr., and All-Tech Chief Executive Harvey I. Houtkin strongly deny the charges.
All-Tech, based in Montvale, N.J., is just one of dozens of day-trading firms being targeted in a crackdown by state regulators (table, page 90). The crackdown may result in significant industry reforms. Philip A. Feigin, executive director of the North American Securities Administrators Assn. (NASAA), which represents state securities regulators, says there are widespread problems among day-trading firms. He is spearheading a national task force to study the industry, with an eye toward stricter enforcement. "They have taken the art of losing money and turned it into a science," he says.
The day-trading industry began in 1988, when federal regulators changed stock-trading rules to allow individual investors to execute trades on NASDAQ more easily. It really took off just a few years ago with proliferation of firms using new software designed to execute split-second trading. Individuals sign on with day-trading firms, which are licensed by the National Association of Securities Dealers (NASD) and have special software that provides information on the flow of orders and instant access to NASDAQ stocks. The day traders monitor small price movements in active stocks, trying to profit from changes of as little as a quarter or an eighth of a percentage point. Individuals execute as many as 100 trades daily and usually close out their positions before the end of the day. The firms make money from the commissions, usually 2 cents to 3 cents a share. Day traders are a small subset of online traders.
But day traders play a major role in a critical segment of the market--the 100 most actively traded NASDAQ stocks. James Lee, president of the industry's trade group, the Electronic Trading Assn., says there are about 40 day-trading firms nationwide, but eight control 85% of the market. All told, the industry represents 12% to 15% of NASDAQ's daily volume, he claims.
Some of these firms are promoting electronic day trading as a way to make a lot of money. But industry regulators are keeping a close watch on those marketing claims, which sometimes hide the risks, says Mary L. Schapiro, president of NASD Regulation Inc., NASD's enforcement unit. Schapiro also vows to be tough on promoters who "suggest that day trading is `the best entertainment since television"'--a claim All-Tech's Houtkin made in a radio interview last fall.
PROFIT WATCH. Regulators are also discussing whether day-trading firms need to take more responsibility for their clients' trading. Under current rules, brokers must make sure that the investments they recommend, such as stocks, futures, or options, are suitable for their clients' financial position. Now, with firms pushing day trading for novice investors with limited capital, "there's a question where a suitability requirement exists when a company is recommending a trading style rather than a product," Schapiro says. No new rules are yet on the table, but "we [regulators] talk about it a lot," she adds.
David Schellenberger, a Massachusetts enforcement official who heads NASAA's task force on day trading, says he wants to find out if any day traders actually make a profit. In one enforcement case brought against a Massachusetts branch of now defunct Houston day-trading firm Block Trading Inc., the state found that 67 of 68 customers lost money. "If no one is making a profit day trading, that raises a disclosure issue," says Schellenberger.
State regulators have been aggressively going after firms that make misleading and unrealistic advertising claims. They are also concerned about the financial stability of such firms, and whether regulations adequately protect consumers and the markets.
Feigin says the capitalization of many day-trading firms is too thin. The problem is compounded because some firms offer day traders no-money-down loans or rely heavily on margin from clearinghouses, he says. Feigin's worry: Trading revenues may not cover losses in the event of a market downturn.
Day traders rely heavily on margin to leverage their capital. They typically start with $50,000 to $100,000 of their own money and double it by borrowing on margin. Many traders also rely on loans from family or friends, signing partnership agreements that spell out how the parties will split profits and losses. Some states, including Massachusetts and Texas, claim that these arrangements violate state laws that require individuals who trade for others to register as investment advisers. But the Electronic Traders Assn. claims that without the agreements, the industry would be "seriously undermined."
GYRATIONS. Not surprisingly, the established Wall Street houses are the upstart day traders' sharpest critics. And tensions are running high because of the extraordinary valuations of Internet stocks that have left most professional investors on the sidelines. Muriel F. Siebert, chairman of discount broker Muriel Siebert & Co., believes day traders are responsible for irrational volatility in stocks, including her firm's own, and that the industry should be subject to stricter licensing rules. "You can't let these people go wild," she adds.
Merrill Lynch & Co. Vice-Chairman John L. Steffens believes day trading has made a casino out of the market. He says day trading has caused problems for Merrill customers, since it is hard for Merrill to execute orders for a stock that is gyrating wildly. And he says day trading is a good way to lose money. "I think this day trading and the kind of volatility it has created is not good for anybody. It's not a heck of a lot different than betting on red or black." Houtkin contends that the big brokers feel threatened by competition, now that the small guys have the same access to the markets that they do.
Houtkin may have a point. But unless the day-trading firms clean up their act, the regulators are likely to do it for them.