Sunday, August 9, 2009

Is it possible to succeed through day-trading?

I am reading Beat the Market by Ed Thorp and Sheen Kassouf, which has the subtitle "A Scientific Stock Market System".

In the first few pages, he discusses "chartists" which sound very much like what we now call "day traders".
Chartists, or technicians, believe that patterns of past price performance predict future performance. They rely solely on price and volume statistics from the ticker tape, claiming that insiders have already acted by the time statistics such as sales, earnings, orders, and dividends are published. Technicians claim that various configurations on their charts, such as heads and shoulders, triangles, wedges, and fans, repeat themselves over and over again, signaling the start and the reversal of price trends. Thus by studying price charts, they believe they can detect trends soon enough to profit from them.

Chart reading seems scientific but it isn't. For instance, the most celebrated of all technical theories is the Dow Theory. Richard Durant's What Is the Dow Theory? asserts that $100 invested in the Dow-Jones industrial average in 1897 would have grown to $11,237 by 1956 if these stocks were sold and repurchased whenever the Dow Theory gave the appropriate signal. This is equivalent to 8.3% compounded annually. By comparison, the University of Chicago's Center for Research in Security Prices found that random buying and selling of stock from 1926 to 1960 would have averaged a 9% gain per annum, about what the Dow Theory claims to have earned by design.

My doubts about chart reading were strengthened by a test I gave to people who claimed to be able to "read" charts. I selected pages at random from a chart book, covered the name of the corporation and the last half of the chart, and asked what price change the "pattern" indicated. Their "predictions" were no better than those of someone making random guesses!
It seems that most day-traders lose money... 80 to 90 percent, if this Slate article Day Trading is for Suckers is to be believed. And worse:
The thing that is most remarkable about day trading, though, is the almost complete absence of a coherent investment theory that could justify the practice. If you read Warren Buffett or Peter Lynch or John Burr Williams, you get a clear sense of the principles that guide their investing. But if you talk to day traders and try to figure out why they believe they can beat the market, you don't get any real ideas. You just get a host of anecdotes about great trades.

I had mostly dismissed the idea of day-trading as my understanding of investing has come from proponents of index funds and long-term investments, but a friend had recently suggested that long-term investing is hard because you need to know things about companies to be successful (which may be true if you define success as beating the index funds), whereas short-term investing is a game you can potentially win at just by studying price movements. From all of the above and because there is friction in the form of high transaction fees to overcome, I tend to conclude that, assuming it can be done at all, this is a very hard thing to do.

Ernie Chan's blog discusses quantitative and algorithmic trading and investment schemes. There seems to be a lot of sound analysis from the standpoint of information theory. Skimming through the posts, I did not immediately find evidence that such strategies can be successful. The closest I have found so far is a post called In praise of day-trading which ends this way:
Let me tell you a little secret: in my years working for hedge funds and prop-trading groups in investment banks, I have seen all kinds of trading strategies. In 100% of the cases, traders who have achieved spectacularly high Sharpe ratio (like 6 or higher), with minimal drawdown, are day-traders.
The Sharpe ratio is defined to be (the rate of return minus the rate of return of some risk-free investment (like CDs)) divided by the standard deviation of this value. It is essentially the signal-to-noise ratio of the extra return you get from taking risk on a particular investment. There is no indication of what kind of strategies these successful day-traders were using, nor over what period they were able to sustain such high returns, but the implication is that, for some people, day-trading can work.

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