But whatever the reasons, the new day-trading mania is not likely to result in a happier outcome than the last one. There are many theoretical reasons and a wealth of empirical evidence to suggest that most day traders are wasting their money.
One of the most important concepts in finance – and yet seemingly one of the hardest to understand – is that there are two sides to every trade. For a day trader to make money, someone else has to lose money. In the most optimistic case, the loser could be a normal person who needs to put money in or take money out of their retirement account, and who therefore doesn’t worry much about the price at which they buy or sell. But most trades are not this. Instead, day traders are usually buying and selling either from one another, or from algorithms programmed by skilled, experienced financial professionals. If it’s the former, their trading is a zero-sum game. If it’s the latter, human day traders are very likely to lose because the people who program trading algorithms are typically very smart, and their computers can spot market-moving developments faster than people can. This is why professional human traders have been increasingly driven out of the market.
If inexperienced investors start betting large amounts of their money on individual stocks and options, they’re courting financial ruin.
A related problem is the idea of slippage. Day traders might think that because they’re paying zero commission, their trades are free. But when a day trader places an order, a trading algorithm somewhere quickly figures out that they want to buy or sell, and raises or lowers the price accordingly so the day trader gets a less favourable price.
Another reason day trading is a bad idea is that people often fail to understand when they’re winning and losing. If the market as a whole goes up (as it has recently), many stocks will be winners. That can make a day trader feel like they won, even if they would have made as much or more money if they had simply bought an index fund and held onto it. This is especially true right now, when correlations between stocks are very high – in this case, meaning many stocks are rising or falling together.
Finally, day traders often don’t understand the amount of risk they’re taking. Call options of the type my college friend bought, for example, are a form of leverage – you might make fabulous riches, but you’re very likely to lose your money. Investors may not be prepared for how much money they can lose with the trades they’re making.
A large amount of empirical evidence confirms that most day traders lose money. A very large 2004 study of Taiwanese day traders found that more than 80 per cent lost money. A tiny number – about 0.03 per cent – earned consistently large profits, but the odds of possessing this kind of skill are slim. Most studies of day traders in the US and Finland yield similar results – a few traders are consistently good, but most lose out.
Day trading might therefore be a fun way of gambling for those who are locked inside waiting out the pandemic. But if inexperienced investors start betting large amounts of their money on individual stocks and options, they’re courting financial ruin. If you want to day trade, the best thing to do is to bet only a small percentage of your money to learn whether you’re one of the few who has the skill to beat the market. Day trading should be treated like an expensive video game, not like a way of getting rich quick.
Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University.