Saturday, December 08, 2007

Some Day Trading Issues

Last week a subscriber wrote and mentioned that he was getting in and out of trades more quickly than he had in the past and had even entered and exited the same position in the same day. That action resulted in a warning from his broker about day trading. Though I certainly do not consider myself to be a day trader, I do enter and exit positions at least occasionally on the same day, I am aware of the day trading requirements established by the NASD and by my own brokerage firms.

"The following general requirements regarding day-trading have been imposed by the NASD:

  • Pattern Day-Traders are characterized by transacting four or more stock or options day-trades within a five-day period in a margin account.
  • Pattern Day-Traders must maintain at least $25,000.00 in account value in order to continue day-trading practices.
  • In the event that a Pattern Day-Trader does not maintain $25,000.00 in account value they will be required to provide cash-on-hand for same-day stock transactions.
  • Additionally, an account may be flagged for day-trading if it regularly recycles funds within the same day, for example, an investor sells a security (stock or option) for a premium of $400 and proceeds to purchase another security (stock or option) for $400 when no other capital is available and prior to funds being cleared.
  • If an account becomes designated as a pattern day-trading account and does not maintain the minimum required equity, at least $25,000.00, a call will be issued which must be met within 5 business days, otherwise the account will be restricted to Cash only for a period of 90 days or until the account equity is brought above the minimum equity requirement or at least $25,000.00."

    The NASD Day-Trading Risk Disclosure Statement also sets out some considerations for the potential day trader (one who uses an overall trading strategy characterized by the regular transmission by a customer of intra-day orders to effect both the purchase and sale of the same security or securities). Undoubtedly one should consider these as serious warnings.

    Among the points made by the NASD, are that day trading can be extremely risky and is not appropriate for someone who has limited resources and/or limited trading experience. The trader should be prepared to lose everything used for day trading. They also indicate that "certain evidence" indicates that an investment of less than $50,000 will significantly impair the day traders ability to make a profit.

    As if that isn't enough, the NASD also points out that day trading on margin could result in losses beyond the initial investment. Multiple commissions, of course, add to the difficulty in attaining profits.

    I am not a great fan of day trading since so many have lost so much through the practice. I am on board with the NASD's advice to be cautious of claims of large profits from day trading. Certainly, some have made fortunes day trading, and for that reason it can be tempting. Many more, however, have been losers so heed the cautions and do your homework before considering the strategy. Even after achieving an understanding of the significant risks, the prospective day trader needs to understand his own trading emotions very well and be able to attain great discipline before putting any money at risk.

    Bill Kraft, Editor


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    13 comments:

    Anonymous said...

    Very good article

    Anonymous said...

    All I ever do is day trades and I have had only one loosing trade all year. In a ten day period the profits average 1000/ what is wrong with that?

    Bill Kraft, MarketFN.com said...

    That's great, Anonymous. How many trades did you make? Nothing wrong with $100 a day; that's $36,500 a year. Hope your trades continue to do well.

    chuckbarry said...

    Informative article to me.
    I have only this year began trading.
    I did 143 trades since April with $102,843 in profits and $23,600 in losses so far. I sell my holdings immediately when they turn negative against my costs. This is when my brokergae characterized my account as a "DAY TRADER", and my only intent was to avoid losses that may get away from me.
    I bought AAPL in June and sold the JUL 140 Calls against my shares for $15,124 profit in July. My biggest gain.
    I recently paid down $93,000 in short-term debt. However, my brokerage never gave me five days notice when my account dipped below $25K the end of Nov. This has hurt me this past week although
    I have substantially more money than $25K in the account.
    My brokerage never gave five days notice that my margin account was converted a 'cash' account.
    I was forced to buy 1500 AAPL options instead on being long the AAPL shares. Who am I to complain :)

    GeorgeT said...

    Hi Bill,

    As pointed out by Mandelbrot, the key characteristics of market volatility is fractal or self-similar, hence shortening the trading time frame does not increase the trading risk at all, but indeed reduce it to the square root of its original intensity. Moreover, going flat at the end of a trading day can also eliminate the over-night price surprises. Of course, the trader has to be more agile to capture the daily price fluctuations. Although the price trend within one day is small, traders can have much higher leverage to compensate for that. However, it all comes to the temperament and style of each individual to determine the best fit for each individual. Definitely not because day trading is more risky than the other trading styles. Apparently, the buy-and-hold investors lost much more than all day traders combined during the 2001 stock market debacle. Holding stocks over-night already exposed one's hard-earned capital to unnessary risks, the longer holding period, the more risks you expose your money to. Trading longer term actually has more risks than day trading, provided that a day trader is disciplined and has good money management skills in taking advantage of the higher leverage.
    After all, discipline and money management skills are critical to longer term trader as well.

    Bill Kraft, MarketFN.com said...

    Way to go, Chuck. I guess some have more unsettling complaints though it might be worth talking to your broker about the lack of notice issue to see if they would take you off the 'cash account' status. There are a lot of brokers in the world. Anyway, sounds like you have had a great first year.

    Bill Kraft, MarketFN.com said...

    Well, George, I never met Mandelbrut, but I do agree that it all comes down to the temperament and style of the individual trader. For example, I do not believe that the market is soluble by mathematical formulae alone because they cannot account for the timing and breadth of emotional moves, the so-called "black swans" that move the markets through extremes of fear or greed.

    George said...

    Billl, all the academic studies based on mathematical models claim that day trading and short-term trading as well are trading with noises (as Fischer Black put it, short-term traders are 'noise traders'), which is a loser's game, buy-and-hold is the only way to go. If you don't believe the market can be modeled mathematically, then there's no reason to believe that day trading has much higher risks.
    Regarding the 'black swans' don't you think they hurt the longer-term traders even more ?

    Bill Kraft, MarketFN.com said...

    Hi George. Please remember that I was quoting and paraphrasing the NASD's comments on day trading. I am not a buy and hold trader and I have been trading for my living for quite a number of years now with pretty reasonable success. I may be trading "noise" as you say, but, for me over the last 9 years it certainly has not been a 'losers game' in practice. I think "black swans" are simply something traders need be aware of and I doubt (though I haven't investigated) that they hurt longer term traders any more since they are, indeed, rarities which a trader may use to his advantage on occasion, but against which all traders should guard. With respect to mathematical formulae, how can one construct a formula that accounts for a 911 event or the indictment of a CEO or a swift market reaction to a surprising and spectacular news announcement? Please understand that I am not saying that mathematical formulae do not have a place -- they do. I am saying that I do not think one can be constructed in such a fashion as to be a "holy grail." I fear too many do seek such a "holy grail" of trading and I think that is a mistake.

    George, you say the academic studies say buy and hold is the only way to go. If that is so, please answer the question: "Hold until when?" "Buy and hold" suggests that profits never be taken since there is no message about when to exit. Holding until death does little for the investor, but may serve his heirs greatly. Lastly, are we able to identify any academicians who have become wealthy through investing? I'm sure there must be a few.

    Please don't get me wrong, I do believe 'buy and hold' can be a wonderful strategy, but I also believe there must be some predetermined exit even for the buy and hold trader. Otherwise how does one succeed in following the sage advice to cut losses? I hope you'll take the time to read my new book, "Trade Your Way to Wealth: Earn Big Profits from No-Risk, Low-Risk, and Measured-Risk Strategies." I set forth a number of strategies beyond buy and hold offer profits on a shorter time line than holding forever and some even assure a profit upon entry while some have literally zero risk provided we have a stock market and a country. The book will be released in January and is now available on pre-release at amazon.com.

    George said...

    Hi Bill,
    Thanks for taking time to clarify your quoting NASD's comments on high risks of day trading.

    The point I tried to make originally is that day trading is not any riskier than any other styles of short-term trading like what you have been doing in the last 9 years.
    You brought up the 911 as a black- swan event, don't you think that this event just hurt the swing traders who longed stocks right before 9/11, while the day traders might even benefit from this black swan event. So how do you justify that "day trading is much riskier" as what you quoted and paraphrased from the NASD's comments?

    Apparently, you don't believe in long-term buy-and-hold strategy; being a proprietary trader, I don't think that is a sound strategy either. What contradictory is that you're practicing short-term trading yourself but quoted NASD's comments as a fact that day trading is a high risk venture. Don't you think that the financial economists who advocated for long-term investing consider your short-term trading style to be high risk as well? i.e., the misconception that you have for day trading is exactly the same as what the academics have on your trading style.
    It certainly would be interesting to read you book, especially to see how you differentiate the trading risks of holding equities for one day or few weeks.

    Bill Kraft, MarketFN.com said...

    Hi George, I quoted and paraphrased the NASD information because it adds to trader awareness. I'm not against "buy and hold," as you suggest. I would just like to know the answer to the question I last posed to you: "Hold until when?" Apparently you have the mistaken impression that I trade short term only. I personally do hold a number of positions for quite a long time, but I always try to have an exit strategy going in; when the exit is hit I'm out whether the hold has been long or short. Through practical experience, I have found that I am taken out of many positions within relatively short time periods (up to 6 weeks or so) and thereby often avoid moves opposite to my position. I am in other positions for longer times because the profits continue to run. All trading, whether short term or long term, involves risk. One added risk of day trading about which the day trader must be aware is that two commissions will be paid every day on every position. The additional cost obviously adds risk since the trader must make higher profits to cover the many commissions. The buy and hold investor, on the other hand, runs the risk of sitting through deep, deep retracements that may or may not ever get back to profitable before the trader dies. Suppose, for example, that one were a buy and hold investor and bought the Q's (QQQQ Nasdaq 100 tracking stock) at $120 in March of 2000. Now, almost 8 years later, the Q's sit near $57, less than half the price. How happy would that buy and hold investor be today? What did he do to cut losses? It seems your quarrel is more with NASD than with me. If you want justification for their position, it might be better to check with them.

    Anonymous said...

    I ma not clear on the NASD requirement. Can you help clarify the following scenario?

    If I buy (not sell) an option (no pither positon held), all I am risking is the amount of the option. If the option trades @1.50, my maximum risk is $150. now if the option goes to 1.70, and I sell it the same day, and let's say I do the same thing 4 times in a day for 5 consecutive days is it day trading? Why would I need 25k to rick $150?

    Bill Kraft, MarketFN.com said...

    Dear Anonymous-
    Pattern day trading is a designation by SEC applying to any individual who buys and sells a particular security in the same trading day at least four times in a five-day period, and for whom same-day trades make up at least 6% of the trader's activity during that period. Pattern day traders are subject to special rules. While that may not seem to make sense in the scenario you set out, it is the SEC's definition. You should check with your broker to find how they apply that to your own situation and determine whether they have any additional special requirements if your trades fit the requirement of pattern day trading.
    Bill Kraft