Why day trading doesn’t work
As a strategist, I am obviously inclined to dismiss day-trading as little more than gambling. Every time I do that, however, some retail trader (though typically not professional traders, but more on that later), comes up to me and tells me about how he makes money (and I use the terms ‘he’ advisedly, here). Well, here is my challenge to you. If you knew with perfect foresight what the news would be tomorrow, would you be able to make money?
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Of course, we all would be able to make tons of money if we had the perfect crystal ball and knew exactly what was going to happen. Victor Haghani and James White from Elm Partners set up an online game where you can test your abilities as a day trader with perfect foresight. The game is available here: https://elmwealth.com/crystal-ball-challenge/
For their research report, Haghani and White recruited 118 volunteers all of which were trained in finance and let them invest in either the S&P 500 or 30-year US Treasuries with the ability to use leverage between 50x short up to 50x long. These volunteers were given 15 randomly selected trading days, one from each year between 2008 and 2022. For each day, the volunteers saw the page of the Wall Street Journal with stock and bond prices blacked out. Below is a screenshot to give you an idea (note that in the experiment, the volunteers can click on the newspaper to read it more clearly).
Screenshot of the trading game
Source: Haghani and White (2024).
You’d think that people would make a lot of money in this game. At the very least they might have a high hit ratio of getting the direction of the stock and bond markets right. I guess I let the authors speak for themselves:
“The players in the proctored experiment did not do very well, despite having the front page of the newspaper 36 hours ahead of time. About half of them lost money, and one in six actually went bust. The average payout was just $51.62 (a gain of just 3.2%), which is statistically indistinguishable from breaking even. The poor results were a product of: 1) not guessing the direction of stocks and bonds very well, and 2) poor trade-sizing. The players guessed the direction of stocks and bonds correctly on just 51.5% of the roughly 2,000 trades they made.”
That is a horrendous outcome for day traders. Let me repeat that: Even when they had perfect knowledge of the future, they still were no better than chance.
Now imagine what happens when they don’t know what happens tomorrow…
The authors however also show something important: The advantage experienced professional traders have. They recruited five top level professional traders, like top traders from a macro hedge fund, the Head of Trading at a major investment bank and the like. These five traders were right about market direction 63% of the time, significantly better than the 51.5% of the retail traders.
And their trades were vastly more profitable with an average gain of 130% compared to the 3.2% of the retail traders.
What did these top traders do different? Two things, it seems. First, they didn’t trade that often. They decided not to take any positions on one third of the days, preferring to sit out the days when the signal wasn’t as clear as they wanted it to be. Second on the days they traded, they sized their trades according to risk, taking on more leverage on days when the signal was stronger and less leverage when the signal was weaker.
And these are lessons for every investor to learn. Avoid the noise and learn to differentiate between signal and noise. Plus, bet big when there is a clear signal and bet small when there is a weak signal.
You’re correct however that last sentence is doing a lot of work.
As on the average, on the stock market, there are more rising than falling days, if one always places a buying order, for the same amount, one should be winning. I am waiting to become a millionaire and try it.:)