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 follow 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 cookie-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:
- Speed Trading. This was one of the earliest ways in which “daytraders” profited. When markets traded with fractions, there were abundant opportunities for traders to capitalise 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 speed 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 follow 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 “speed trading” the larger institutions recognised 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 favourite. On my first day of training, my trainer told us to memorize 5 names in 10 sectors. I took the leap to familiarise 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 recognising 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 recognising interrelationships between sectors (like when the steel stocks were running, the metallurgic coal stocks would follow 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 recognising 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 familiarising 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 mean.
Over the past 10 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…