DAY TRADING: IS TIME RUNNING OUT?
by: Philip Gotthelf
OK, we’ve all heard about the day trader who shot his broker for lack of performance. However, this is not exactly a challenge of day trading as much as it may be the theme for a television drama. The question for the new age of market volatility is whether day trading really provides the returns commensurate with the thrills – depending upon one’s definition of thrill. If you believe in the efficient market theory and agree that a growing number of investors have access to the analysis and execution platforms for this exacting investment practice, you may conclude that the clock has been ticking and time may be running out.
Thanks to the Information Age, most investors understand the concept of day trading—to capture profits from small intraday price movements in everything from stocks and bonds to commodities. But before computerized trading platforms, the physical effort and time required to day trade prevented most individuals from doing it in the first place. Requirements to write an order ticket, time-stamp it, call it to the trading desk, have it wired to the floor, get an execution and receive the fill frequently consumed the very moments when the best profit opportunities came and went. This is not to say day trading was not done, but it was a trading specialty limited to the “downstairs crowd,” or the floor traders. Needless to say, mechanized trading processes have revolutionized day-trading culture and spurred growth in the number of day traders.
Still, a computer cannot erase every set of pitfalls a day trader faces. In fact, the historical inadequacies associated with order processing parallel today’s drawbacks. Despite lightening-fast trading platforms and electronic markets, one must still physically enter the order. An exception to this rule might be the fully automated trading system that permits a computer model to execute and monitor day trades as well as spot them. Such programs are rare even as computers and software models become more sophisticated.
More common is the workstation that the day trader attends to himself, where he selects trades based on a technical computer model, intuition or both. Once identified, the strategist must enter the trade, monitor progress and execute an exit. Of course, there are multiple ways to do this.
Day-Trading Methodologies
At first glance, day trading can appear to be relatively simple, particularly if the decision model is not too complex. Common methods include ratio-to-open, swing trading, five-minute bar charts or some other time increment, random market simulation and momentum riding. Let’s take a brief look at each one of these methods.
The ratio-to-open approach presumes a market will move a certain distance in either direction from the open. This is a truism, of course, because prices inevitably move up or down from the open; the key is to statistically determine the size and probability of the move. Ratio traders usually use historical data to create statistical profiles of price behavior called “histograms.” These data representations provide special statistical measurements that give the probability of each move in accordance with its distance in much the same way a statistical model can predict the chance of a poker hand turning up as a royal flush.
Using the histogram, ratio traders enter buy or sell orders at the open with a predetermined exit based on the ratio from the open that yields the highest statistically determined payout. Often a risk-aversion model is added on top of this decision process to manage money. Using the two synergistic techniques, the trader hopes to capture consistent random price movements that are statistically determinable.
Swing trading has become increasingly popular and involves identifying swing points that usually are based on a momentum-exhaustion theory. Although swing trading has been defined as an approach lying between day trading and trend trading, the original theories behind swing trading dealt with momentum measurements. The basic premise is that all market movements of “profitable duration” have five basic phases. The first phase is the ignition that starts the move. Ignition is identified by a consecutive change in price direction. This is followed by acceleration; as the name implies, the price move increases speed over time. The next phase is deceleration as the price move loses speed. Deceleration is followed by consolidation where the price action stalls. Finally, the market reverses.
The five phases of a swing cycle should not be confused with wave theories that presume markets move in five waves. Think of the swing as having stages from start to finish that are all in the same direction, whereas waves cycle up and down in varying amplitudes. Having made that distinction, the swing trader seeks to identify a move in progress and its phase. Once locked onto the progress point, the trader anticipates a reversal that is, hopefully, the ignition of an opposite move. If the phase is successfully identified, the trader holds the position until consolidation that usually signals an exit.
Minute-by-minute bar charts use the same logic as daily, weekly and monthly bar charts. The only difference is the time interval. Using a five-minute bar chart, the day trader tries to recognize and act on typical formations that include breakouts and reversals, support, resistance, flags and pennants, or even head-and-shoulders patterns. This approach requires careful and constant monitoring. Many successful day chartists claim their practice is as mentally stressful and draining as a championship chess match. Lunch is unheard of! Before attempting minute-by-minute charting, ask yourself, “Do I have the intestinal fortitude and mental stamina to participate?”
Random market simulation establishes statistical models based on random number simulation. Names like “Monte Carlo simulation” and “gaming theory” commonly are used to identify the more popular random market simulations. In some respects, random market simulation is similar to the ratio-to-open method. Frequently the same statistical models are implemented. The major difference is that the ratio-to-open trader usually has a single trade established from the open. Once the ratio is achieved, the trader packs up and waits for the next day’s open. The random market simulator uses the statistical model to calculate probabilities for moves after the initial opening movements have occurred. In other words, the probability model is continuous throughout the day.
As the name implies, momentum riding attempts to ride daily price momentum in an identified direction. Common tools for momentum riding include moving averages, stochastic values, relative strength indexes and trendlines. For day trading, of course, time increments can be as small as a minute or as long as an hour. The theory behind momentum day trading is that a price in motion will remain in motion unless acted upon by some outside force. In the day trader’s world, the outside force is often an inside trader who acts in an unforeseen way!
Some Constraints
The aforementioned list of day-trading approaches is far from comprehensive. In fact, there are hundreds, if not thousands of combinations and permutations for each method or combination of methods that can and do fill books. Without going into the merits of any methodology, all day trading suffers from the same constraint – time. Day trading involves executing strategies within highly limited timeframes. The longest is from open to close. The shortest can be a few seconds. In all cases, once the time limit is imposed, there is no flexibility unless the day trade is extended to the following day’s (or night’s) session, in which case it no longer is a day trade. Given the time constraint, an obvious pitfall is any potential lack of price movement within the defined interval. If a trade cannot be completed within the allotted time interval, it must be abandoned.
In addition to the time constraint problem is the problem of transaction velocity. There are two facets of transaction velocity. First, of course, transaction velocity is associated with trading frequency, and the more frequent the trading, the higher the transaction costs. The second aspect of transaction velocity, often ignored, is apparent only when trading is ongoing. As alluded to at the beginning of this article, there is a physical process required to formulate, enter and exit a trade. Some models are too sensitive to allow a realistic physical market entry and exit.
As an example, I recall a system I’ll call “X” to avoid casting aspersions on the creative process of the system’s inventor. System X dates back to the introduction of handheld programmable calculators. A day-trading system was programmed into a handheld that consistently identified $0.02 price movements in soybean futures. The problem was that the $0.02 moves would come and go before a trader could post the entry and exit orders. The computer simulation then assumed you had executed a trade when, in fact, you were out when you were supposed to be in and in when you were supposed to be out!
More emphasis, by far, has been placed on day-trading transaction costs. Although rates can be negotiated down to bare bones, even at the lowest cost levels a high-velocity system can chew up profits with commissions. This is why many day-trading systems that look great on paper turn out to be duds when used in real markets with real commission costs.
Fortunately, a growing emphasis is being placed on physical demands of day-trading, which includes time required to execute entries and exits. The common term associated with this, of course, is slippage. In many cases, by the time a trader has identified a trade, entered the order, received a fill and calculated an exit, the intended transaction has been missed. Even if not completely missed, there can be considerable erosion between the amount anticipated and the amount realized. If this is characteristic of the day trader’s approach, profitability will be negatively skewed.
Physical demands also include the routine of getting up every morning, mounting the saddle and riding the market from beginning to end. It may sound easy, but day trading can be extremely exhausting. Unless you have nerves of steel and a cast-iron stomach, day trading will extract a physical toll. Among the exhaustion symptoms I have experienced or witnessed friends and associates experiencing are headaches, digestive problems, sleeping disorders, tension or anxiety, irritability, delusion and depression.
Consider the advertisements. “Spend just a few minutes a day…” “Enormous profits from intraday moves…” “Learn how to day trade for huge gains…” Indeed, some day-trading stints can generate substantial returns. The ultimate goal is to retain the winnings without sacrificing health, happiness and family. Ad copy tells about all the advantages and may have dozens of endorsements. We never hear about failures in marketing literature and pitches.
System Failures
Another interesting and almost stealth day-trading pitfall is system failure. System failures can range from your workstation’s meltdown to a platform failure and even an exchange’s system crash. Without describing all the details, I was involved in a successful day-trading system for one of the commodity markets. In the middle of my session, the entire exchange platform crashed, and I was left with open positions and no way out. And the market, of course, was not going in my desired direction. Suddenly I was confronted with a new and totally unanticipated risk. What do you do when an electronic market fails in the middle of your strategy?
I learned an important lesson about the advantages of side-by-side markets. These are markets that have both electronic order matching and open outcry execution. I also learned the importance of overnight sessions and global markets. Admittedly, day trading should not necessarily turn into night trading. Yet there was a time when the lack of liquidity during the night session extended an advantage to intrasession methodologies. Anyone who has traded energy or currency products certainly understands what I am saying!
One of the worst expressions bantered about by brokerage firms is “not held.” These two words can engender the most awful, sinking feeling imaginable. The term means your broker is not held responsible for a lack of execution. If you read your account agreement, it is likely you will find language disavowing any responsibility for your order execution with the exception of willful misconduct or gross negligence. If you have never had to prove willful misconduct or gross negligence when asserting a claim, keep it that way. I have found it next to impossible to successfully argue that a brokerage firm acted with willful misconduct or gross negligence. Even in a case like Enron, the chance for recovery from a broker is slim.
The danger of a not-held situation is that your quote screen may flash that your objective has been reached when, in fact, there was no trade on your behalf. Thinking that you are in the market when you’re out or the other way around may cause you to execute another leg of your strategy. Alas, you can find yourself in unintended positions that are exactly the opposite of your intended winning strategy. By the time you learn you were not filled, you might execute dozens of trades based upon no position.
Is Anything Moving Out There?
Finally, there is the timing aspect of the day-trading environment. Good day-trading environments come and go. The day trader does not always have a continuous opportunity to cull profits from daily price fluctuations. The most deadly environment is one where there is very little movement. System sellers will insist that there are always stocks and commodities that move. All you have to do is find the right market at the right time. For example, the S&P 500 Index futures contract is one of the most popular day-trading vehicles. This is because the full S&P futures contract does not have to move very far to generate large gains. Leverage is impressive. Hardly a day goes by without modest price fluctuations. However, sometimes stocks and commodities reach a state of equilibrium. If intraday price ranges lack the breadth to realize profits, no day-trading method is going to work.
System developers encourage participation by pointing out the massive number of trading vehicles available. Foreign exchange, precious metals, penny stocks, new offerings, bankruptcies, mergers and acquisitions all have associated volatility. Federal Reserve policy can send markets soaring or crashing hundreds of points for profit potential in the thousands of dollars and hundreds of percentage points. But what if volatility dries up?
There is a tendency to become restless and impatient when markets fall into a volatility slump. It is in this environment that day traders become careless, over anxious, greedy and even desperate. A fundamental and exceptionally important rule is expressed by the saying, “You can’t squeeze blood from a stone.” In the day trader’s world, you can’t squeeze profits from an inactive market. Whether you use a ratio-to-open approach, swing trading or a random walk simulator, there must be enough intraday price movement to trigger your decision-making process, enter your trades and take your profits. It may be true that the current global economic picture is ripe for continuing intraday volatility. It is important, however, to accept the possibility that favorite day-trading vehicles can calm down or, alternatively, become too efficient to ante up intraday profits.
Too Much Going On?
In sharp contrast, there also is a problem associated with excessive volatility and huge losses associated with some of the more popular day-trading markets. Most recently, crude oil and its sister products staged a massive intraday reaction to the potential damage of Hurricane Katrina. Depending upon when you assume the day begins, the evening session on Sunday, August 28 witnessed a swing in crude exceeding $4 and a contract change in natural gas approximating $20,000 per position. Within 12 hours of the reaction, energy markets retraced more than 60 percent. Any glitch in a day-trading methodology – inclusive of order entry and tracking – could have spelled disaster. In fact, some brokerage firms suspended day-trading privileges in the energy contracts as a preemptive measure against uncontrollable losses.
Consider that after trading a year or more for little bits and pieces of profit, the day trader’s entire effort could be canceled by a single volatile and unpredictable day. In fact, Katrina herself was a fooler that went from a non-event tropical storm to a Category 4 hurricane in about a week.
As astute investors realize day-trading drawbacks, they may set the stage for a swift and comprehensive exodus away from day-by-day techniques.
Take the Time to Make Wise Decisions
Not long ago, I attended a day-trading symposium in Las Vegas, Nevada. I was immediately struck by all the presentations that boasted perfect records. I thought to myself, “Wow, no one ever talks about losses around here!” Track record upon track record suggested Las Vegas was El Dorado in disguise, and every booth at the symposium had a copy of the key! When I played with the numbers and researched some of the claims, it was apparent that performance was reported absent of any of the pitfalls. Disclaimers should be taken seriously! Like any eternal optimist, I’d like to believe there is a way to get rich by spending just five minutes day trading in front of a computer screen. In fact, I’d be happy if it was as much as ten minutes a day.
One thing I have learned is that an entire day in front of any trading platform requires a personality few traders have. Whether you believe in the Almighty or not, we know that our time on this earth is limited and there is no physical evidence of a return trip once we pass on to the next life or simply get planted in the ground. Thus, time for every day trader is truly running out, and it is wise to make a definitive decision about whether such acute trading is worth the potential toll on time, resources, and even health. Keep that in mind when you set out to make your fortune day trading!
