I have just been reading the US Securities & Exchange Commission (SEC) report on "day trading" and I've come to the conclusion that I'm in the wrong business. We Fools are floundering around investing for the long term, denying the existence of "get rich quick schemes" while, all the time, the best such scheme of all time is staring us in the face.

What could be simpler? We should all go and open day trading firms. These are essentially brokers which provide their clients with things like live price feeds and charting software to enable them to think that they can beat the market's daily (or hourly) fluctuations. They then encourage these clients to trade as often as possible. As a result, the brokers rake in huge commissions.

Between 1997 and 1999, the 15 largest day trading firms in the US more than tripled revenues from $144.4 million to $541.4 million and profits from $22.2 million to $66.5 million. Boy, would I like a piece of that pie. Or, rather, boy would I like a piece of that pie if I could live with the disgusting immorality of what I was doing.

Living with yourself would appear to be the only difficult thing about running a day trading operation. It certainly doesn't appear to be difficult to recruit customers. Everyone loves to think that they are somehow different from everyone else. It's a natural and powerful part of our ego which has evolved over millions of years. The day trading firms prey on this. Interpreting the daily (or hourly) whims of the stock market is such a nebulous thing that we can all become convinced that we can do it.

There are about 4,000 to 5,000 active day traders in the USA. However, between them, they are believed to account for about 15% of the trading volume on Nasdaq. These traders pay an average of $16 per trade and make, on average, 29 trades per day. This means that the average day trader needs to make a daily profit of $464, just to break even. The day trading firm obviously doesn't need to do very much at all. It just sits there letting the commissions roll in.

Of course a really Wise day trading outfit will do a variety of things to increase their revenues. They will encourage strategies that involve a large amount of trading. On top of this, around half of the day trading firms have training programs as an additional revenue source (or rather an additional way to fleece aspiring day traders). Unfortunately, the review found that training and experience had no bearing at all on whether a day trader was likely to make money. It was purely a matter of luck.

Apparently, day trading firms even encourage their customers to lend each other money to meet "margin calls" and keep them in the game. It would seem that the firms themselves are not so keen on lending money to day traders. They are, of course, far too Wise for that. After all, it would expose them to some risk. In fact, since day traders almost invariably lose money (I'll come on to that), lending them money to trade is very risky indeed.

Unfortunately, while those that are operating these day trading firms are making fortunes, those fortunes are coming directly from the poor souls who they con into trading through them. The North American Securities Administrators Association (NASAA) commissioned some research on day trading. Thirty accounts were selected at random and analysed. The average account was open for only four months and it was found that 70% of the accounts lost money. All of these accounts were traded in a manner which had a 100% "risk of ruin" (that is, they were almost certain to go bust eventually -- more on this below). The research also found that the few accounts that were successful tended to be the ones that traded less frequently.

Why day traders lose money

Let's say that we expect the stock market to make an annual return of 12%. This is probably a fairly generous figure. This is the expected return, before costs, of the average £1 invested in the market. It is the average return, whether your £1 is invested in unit trusts, index trackers, normal shares, futures, options, contracts for difference or whatever weird creature you're going for. If the investment underlying your financial product is shares, then 12% it is. Of course, people can also invest in ways that benefit from shares going down. In my opinion, this is even worse. It is a bit like trying to push water uphill. You start off with an automatic handicap of 12% per year built in because, if you went "short" of every stock in the market you would, on average, lose 12% per year.

Imagine that you have £100,000. To keep things simple, let's say that you divide it into ten chunks of £10,000 and you invest these chunks in direct equities. Every time you move a chunk of £10,000 out of one share and into a new one, you incur charges. Converting the US average of $16 per trade into sterling, we get £10 per trade. Each switch involves a buy and a sell, so that makes £20. On top of this, you've got 0.5% stamp duty on purchases and that adds another £50 per switch. In addition to all this, there is the "bid/offer spread". Nigel Roberts goes into this in a bit more detail in a recent Fool's Eye View. Here, I'll just borrow his bid/offer spread for the FTSE 250 of 1.8%. So, for each switch, this costs us a further £180.

All in all, every time we switch one of our £10,000 chunks into something new, it costs us about £250. And this is using fairly conservative figures. The wider spread on, say, AIM investments would get us to an astonishing £1,430. Of course, on top of all this, there are probably significant extra costs involved with getting the up to date prices and newsfeeds but we'll ignore these to keep things simple. If you are using things like futures and options, then the costs (hidden or apparent) just get bigger because someone has to be paid for creating the product.

Our (optimistic) average annual return of 12% on our £100,000 would get us £12,000 per year. This £12,000 amounts to the same as the cost of doing 48 trades per year. So, even if we only do one trade of one of our £10,000 chunks per week (with time off for holidays), we should expect to do no better than break even over the long term. If we were to trade one chunk, once every business day of the year (of which I'm guessing there are about 250), then our annual dealing costs will come to £62,500. This means that we would need to be making a return of about 62.5% pa just to be able to expect to break even.

Let's put this in a bit of context. The legendary investor, Warren Buffett, has become famous and very rich by making around 25% per annum for thirty-odd years. His costs are very low since, as with pretty much all successful investors over the long term, he doesn't trade much. Even if we had the stockpicking abilities of Warren Buffett, we would reduce our expected annual return to zero if we traded twice a week (or 100 times per year to be precise). So, even if you're the most renowned investor there is, and even if you're just a "twiceaweektrader", then the chances are that you are going to blow all your money. Well, not blow it exactly, but give it all to your broker. Have you ever wondered who pays for all those brokers to have those nice cars, houses and yachts?

Even if a day trader is lucky enough to overcome his costs and make a profit in any particular year, the chances of this being sustained, year in, year out are minimal. Since the chances of a day trader making money appear totally independent of the level of training and experience, it seems fair to assume that luck is the only decisive factor. If luck is the only decisive factor, sooner or later the odds will come home to roost.

It gets even worse. Even if a day trader were able to engineer things so that he did have a likelihood of making a profit, he would still most likely get wiped out by an inability to manage his risk properly. This is that "risk of ruin" thing that I mentioned earlier. Imagine a rising graph: this might represent a trader making money. Now let's say that our rising graph goes up and down a bit on its way up. The ups and downs represent our volatility, or risk. We can live with a bit of volatility, so long as our overall trend is upwards. The trouble is that if our graph touches the bottom just once, then it stops. We have lost our money and the game is over. The NASAA research showed that most accounts were operated in this way. It is no surprise really that the average day trading account stays open for only four months.

Because of the costs involved, day trading (or even just "weektrading") turns your expected return from the stock market into an expected loss. In my opinion, this turns it from investment into gambling. What is more, it is gambling with very bad odds. If you are determined to gamble your money away, you'd almost certainly get better odds in the casino and you probably would on the horses too. At least casinos and bookmakers openly admit that what they offer is gambling and have the decency not to encourage people to try to make a living out of it.

Questions and comments on this article should be addressed to the Personal Finance message board.

Related Links

• FSA Investor Alert - Day trading
• SEC Daytrading Report
• NASAA Daytrading Report

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