Written by: Corey Janoff
2020 has been quite the year. Given the dynamics of it all, people have found themselves with more free time. Combine that with a volatile stock market, and many individuals have taken up the hobby of day trading stocks. In short, day trading is the act of buying and selling stocks in a short period, usually based on price movements and headlines. Can you make money day trading? Yes. Will you? Maybe. Will you make more from day trading long-term than you would from a diversified strategic investment plan? Unlikely. Is day trading worth it? It depends on what your goals are. Today we will discuss why day trading is generally a bad idea.
What is Day Trading?
As mentioned earlier, day trading is short-term trading of stocks, ETF’s (or other securities) in hopes of making a quick profit. Thanks to technology, you can buy and sell stocks online or directly from your phone on many apps, many of which are free.
It takes two to tango. If you are buying or selling a stock, someone is on the other end of that transaction. Picture trading baseball cards, Pokémon cards, Pogs, Magic Cards, [insert 90’s reference here], etc.; you are exchanging an item you own for an item that someone else owns. For this transaction to go through, both parties have to believe the item they are acquiring will provide more value than the item they are giving up. Otherwise, why complete the trade?
If you are selling a stock, you are doing so because you would prefer to have cash or a different stock. Either you think the stock you are selling will go down in value or believe the other security you plan to purchase will grow more in value.
The person buying that stock from you has the opposite conviction. They believe the stock you are selling is the best place they can invest their money. Otherwise, why would they be buying it?
If you are buying a stock, the only reason is you think it has the most excellent chance of going up in value more than anything else you could buy. The person selling you that stock has the opposite conviction.
(For simplicity, I won’t go into shorting, puts, or calls today. If you don’t know what those terms mean, that’s OK. It’s probably a good thing.)
The concept of day trading implies that you can buy and sell numerous times throughout the day. You may only hold a position for a few hours! Long-term business practices and company growth prospects are irrelevant. Day traders are making moves based on the latest information or price movements in hopes of turning a quick profit.
Who are You Trading With?
Unless you’re someone like Warren Buffet, negotiating preferential terms on multi-billion-dollar investments in companies, you likely have zero idea who is on the other end of that transaction.
You could be trading with your next-door neighbor. You could be trading with a co-worker. You could be trading with a college student at Stanford or MIT who has 8 hours of free time a day to research stocks. You could be trading with a multi-billion-dollar mutual fund or hedge fund. You could be trading with an investment bank. You could be trading with someone who has insider information, even though acting on that information is illegal (they could go to jail, but you don’t get reimbursed if an insider swindles you). You could be trading with a high-frequency trading computer program that can execute transactions faster than you can blink.
Those high-frequency trading systems are utilized by all of the major investment banks and institutions. They can spot your order coming through, quickly buy the stock you want to buy and then sell it to you for a few pennies more than they paid. It doesn’t sound like a big deal, but multiply that by millions (or even billions) of transactions per day, and you can start to see how lucrative they can be. It’s estimated that high-frequency trading algorithms make 50% of stock trades.
You may be thinking high-frequency trading computers are bad news, but in reality, they provide liquidity for the markets that enable people to execute stock trades seamlessly. While they may have an unfair advantage, they serve a crucial role in our stock exchanges.
The point is, you don’t know who you are trading with. Odds are, the person (or computer owned by a large investment institution) on the other end of the transaction is a professional. You, an amateur, sit down at the poker table with a bunch of professional poker players. You can win some hands and walk away with more than you came with. Stick around for long enough, though, and the odds are stacked against you.
Why is Day Trading Bad?
I outlined a significant risk above in that you potentially know less than the person on the other end of the transaction, and you can’t act as fast as their technology allows them to.
Obviously, you risk that you shoot yourself in the foot and lose most of the money you started with.
In addition to that, you have to be mindful of transaction costs. Most major brokerages nowadays allow for no-transaction-cost stock trades, which is helpful. If you’re paying a trading fee on your stock trades, it could be time to look at another brokerage company.
Beyond trading fees, there are bid-ask spreads on stocks and ETF’s. The price the buyer pays and the price the seller receives is not equal. For large companies with high trading volume, the spreads are minimal (maybe one cent). For smaller, less frequently traded securities, the spread could be significant.
I recall not too long ago a client transferred an account over for us to manage, and it had an obscure ETF in it with a $70 spread – meaning there was a difference in the price of $70 between the price the buyer would pay and the amount the seller would receive! If the position sells for $100, you are essentially paying a 70% commission on that trade!
The most significant risk of all is impeding your progress towards your financial goals.
If you are not on track to achieving all of your financial goals in the timeframe you desire, what the heck are you doing day trading with your “extra” money? You should be putting that extra money towards your goals! Pay off your debts faster, deposit more into your children’s college fund, invest more in a diversified portfolio for retirement.
Lastly, short-term successes can instill a false sense of confidence. You may be reading this, scoffing at me, thinking, “I’m up 40% day trading on my own since the spring. I know what I’m doing.” A rising tide lifts all boats. For example, since late March, stocks have done quite well. Pretty much all the major indices are up double-digit percentages during that time. As of this writing, the S&P 500 index is up over 50% since March 23rd, 2020. It would be hard not to make money investing in stocks over the last seven months. As you have heard many times before, though, past performance is no indicator of future results.
I’m all for having a play account with the cash you can spare. Treat your day trading portfolio like your gambling money. If you can afford to lose it all without impacting your life whatsoever, then permission granted. If losing it all would have a material impact on your finances and wellbeing (or if using that money more productively could add noticeable benefits to your financial state), then push pause and think about this for a moment.
Most people are unfamiliar with how investments are taxed. We talk about this in our recent tax-loss harvesting blog post. In short, pretty much any investment outside of money held in retirement accounts (401k, 403b, IRA) is taxed in the year a gain is realized. If a position is sold for more than it was purchased for, you pay taxes on the gain. If you hold the position for over a year, you pay the more favorable long-term capital gains tax. If you hold a position for under a year, you pay ordinary income taxes on your investment gains.
By definition, day traders rarely hold positions for more than a few months, let alone an entire year! Therefore, if you make money day trading, odds are you will be subject to paying ordinary income taxes on those investment earnings.
I supposed paying taxes on earnings is better than not paying taxes on losses. I would rather pay $40 in tax on a $100 gain than lose $100 and pay no taxes. For some of you reading this, though, you are in pretty high tax brackets. Couple that with state income taxes, and you could be paying near 50% tax on your investment gains from day trading.
Good problem to have, but something to be mindful of.
Is Day Trading Worth It?
Time, boredom, and money lead us to sometimes do stupid things with our time and money to alleviate the sense of boredom. If you’re on track to achieving your goals in the timeframe you want to achieve them, and you have extra money to spare, then go for it.
Maybe you were planning on spending $10,000 on an international vacation this year that you had to cancel, and you decided to put that $10k into a play account. Great. If you hit a grand slam with the money, more power to you. Go on two international vacations with the earnings.
If you’re not on track to reaching all of your goals, or you would like to achieve them faster, maybe think twice before you decide to play with the pros for money.
Investments involve the risk of loss, including total loss of principal. Any examples are hypothetical and for illustrative purposes only. You cannot invest directly in an index. Consult with your financial and tax advisor for implications pertaining to your specific circumstances