Day Trading: It's Not Always A Fool's Game

Ken Jennings is good -- extremely good. With 38 straight victories this summer on TV's venerable trivia game, Jeopardy!, the software engineer rolled up a record $1,321,660 in winnings. In his latest contest, he scored $75,000, smashing the old one-day record of $52,000. No doubt, Jennings is a superior Jeopardy! player.

He has mixed smarts, nerve, disciplined study, years of practice, a knack for figuring odds on the fly, and fleet brain-to-thumb reflexes. Yet how many of us would credit his talent and skill if Jennings had done as well by trading stocks 38 days in a row? Conventional wisdom has concluded that day trading is a short-cut to financial ruin. The stock market's ruthless efficiency inevitably makes every trader a loser, or so we're often told. Day trading is about the last thing I would do, yet this orthodoxy makes no sense to me. Yes, trading is tough work. But why must it be a fool's game? Why, when so many Wall Street firms trade profitably year after year?

NOW, THERE'S FRESH EVIDENCE that day trading successfully is not beyond individuals willing and able to commit the time, sweat, and brainpower to build superior skills. Those who dabble will likely lose -- very badly. Do Individual Day Traders Make Money? Evidence from Taiwan, is a working paper issued in May by Yi-Tsung Lee and Yu-Jane Liu of National Chengchi University in Taipei, and Brad Barber and Terrance Odean of the University of California (at Davis and Berkeley, respectively). Noted veterans of behavioral finance, the UC economists have long tracked the moves of individual investors. Lee and Liu, having done research for the Taiwan Stock Exchange (TSE), struck a gold mine of data -- the full exchange trading record from 1995 to 1999, including each trader's identity. The four academics got together, since no similar trove has been available in the U.S. and day trading is popular in Taiwan. As a pioneering study, the results are merely suggestive. But if you think, as Liu does, that Taiwan's day traders act much like those elsewhere, the findings are intriguing. "Day trading is really hard. Most people lose their shirts," Barber says. "But there's a small population that makes a ton of money."

The researchers began by counting some 925,000 individual investors on the exchange in a typical month. They then identified the heaviest traders, a group that was just 1% of the total but accounted for more than half of all individuals' day-trading volume. They bought and sold stocks at a profit most days, but after transaction costs lost money. As for dabblers, the less they traded the more often they lost.

In a second cut of the data, the researchers checked to see if past winners kept winning. They ranked all traders by their success over the prior six months and then split them into six groups. The top-performing group went on to see average daily gains of $251, even after costs. At annual rates, that comes to more than five times the annual per capita income in Taiwan. The second-best group also netted gains, but just $48 a day, while the third group lost money, the fourth did worse yet, and so on.

The odds -- 82% of traders lose -- are so grim that Barber encourages no one to day trade. Yet it seems not everyone who does is a fool. Left for future researchers is what strategies -- trading just a stock two, say -- are winners. Meantime, we can form our own notions about what works. Here's one you might see on Jeopardy! Category: Wall Street Animals. Answer: Neither bull nor bear, they're quick as cats and work like dogs to become wise as owls. Question: Who are successful day traders?

By Robert Barker

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