by Elliot Turner, Wall Street Cheat Sheet

Lately I’ve heard a lot of heated con­ver­sa­tion about the day trad­ing indus­try.  There’s an intrigu­ing debate with opin­ions rang­ing from “it’s a great way to make a liv­ing” to “it never worked in the first place” to “we’re now in the midst of the great shake­out.” But the bot­tom line is: day trad­ing is DEAD.

Two-thirds of the rhetoric focuses on the idea that day trad­ing is a firmly entrenched part of mar­kets with a some­what sta­ble future ahead. I dis­agree. More real­is­ti­cally, a much larger change is tak­ing place with mar­ket struc­ture. Like the extinc­tion of human beings roam­ing the floor of the NYSE, this evo­lu­tion presents a bleak pic­ture for the day trad­ing com­mu­nity mov­ing forward.

The Best in the Busi­ness Exited the Business

I’ve been itch­ing to dis­cuss this topic ever since Schon­feld fired a sig­nif­i­cant chunk of their trad­ing desk. Schon­feld is an inter­est­ing case study in the “prop shop” day trad­ing space. They had been a suc­cess­ful day trad­ing firm which more recently tran­si­tioned into the “hedge fund” model.

In a let­ter express­ing their intent to lay off many day­traders, the firm stated bluntly that “unfor­tu­nately, our vision of the future of trad­ing has changed. It is get­ting much tougher for traders to make a liv­ing or get by.” Therein lies the cold, hard real­ity fac­ing many day­traders and their firms.

The Insur­mount­able Challenges

The chal­lenges for day­traders are twofold. First, com­puter trad­ing (e.g. high fre­quency trad­ing) has sig­nif­i­cantly eroded much of the edge day­traders require to gar­ner a profit. Sec­ond, and per­haps of equal import, has been a court’s deci­sion in the case SEC v. Tuco which is caus­ing pro­pri­etary firms to com­pletely recre­ate their busi­ness model.

This land­mark case requires firms to either take on more of the day-to-day trad­ing risk them­selves or become reg­is­tered Broker/Dealers. If they choose to become reg­is­tered Broker/Dealers, firms must tran­si­tion into a com­pletely dif­fer­ent reg­u­la­tory structure.

The sig­nif­i­cance of this is not to be over­looked. Many firms have either opted to fully fol­low the trans­par­ent route of becom­ing a B/D or entered the less reg­u­lated and more opaque hedge fund industry.

The Scary Shape-Shifting from Trad­ing Firms to Train­ing Firms

The largest fall­out from Tuco stems from the fact that it became much harder for firms to take in deposits from traders right at a time when day trad­ing lost its com­pet­i­tive edge. In order to com­pen­sate for the increased risk and dimin­ished profit mar­gins, many day trad­ing firms have started “sell­ing” their trad­ing exper­tise to pupils want­ing to trade with the firm.

I am trou­bled that at the time these firms were explor­ing ways to find a new com­pet­i­tive edge in a dynamic play­ing field, they started sell­ing what they them­selves knew to be a mar­ket strat­egy declin­ing in effi­cacy. As a result, rather than con­tin­u­ing to explore new edges, these train­ing pro­grams neces­si­tated firms stick with their archaic strate­gies in order to con­vince pay­ing stu­dents the day trad­ing model was worth buying.

The Indus­try and Its Future

Many will out­wardly cri­tique my premise that the day trad­ing edge has dimin­ished. In order to stay objec­tive, I ask those peo­ple to sim­ply open their books and prove they still have their edge. (Appar­ently, Schon­feld is one of the few will­ing to be honest.) Until then, let’s take a closer look at the pri­mary strate­gies deployed by day­traders over the past decade. This will pro­vide a lit­tle clearer pic­ture of the his­tory of the indus­try and its future.

In my inter­view with Justin Fox, we had an inter­est­ing con­ver­sa­tion about “effi­ciency” in the mar­ket. Justin quan­ti­fied “effi­ciency” in a totally new way for me: he made the dis­tinc­tion between “price” and “value” effi­ciency. This got me think­ing about the way in which mar­ket par­tic­i­pants make money.

More gen­er­ally, this is a gross over­sim­pli­fi­ca­tion, but our mar­ket par­tic­i­pants (other than the mar­ket maker) are either value investors, growth investors, tech­ni­cal traders, or arbi­trageurs.  There is cer­tainly some over­lap between the four, and there are some strate­gies which don’t fit any of these labels. How­ever, in terms of investment/trading strate­gies, the pre­dom­i­nant num­ber of mar­ket par­tic­i­pants fit into one of these four cookie-cutter labels.

Day­traders are arbi­trageurs who rely on some kind of price inef­fi­ciency to make an intra­day profit. I’m not sure many day­traders under­stand their place in the mar­ket to the point where they would sub­scribe to the arbi­trageur label; how­ever, at its essence, day trad­ing is the attempt to make money off the market’s intra­day fluctuations.

His­tor­i­cally, there have been sev­eral ways in which day­traders were able to accom­plish this task and below is a sum­mary the most wide­spread of these methods:

1. Speed Trad­ing. This was one of the ear­li­est ways in which “day­traders” prof­ited.  When mar­kets traded with frac­tions, there were abun­dant oppor­tu­ni­ties for traders to cap­i­tal­ize on the spread between the bid and offer price.  This approach fit nicely with the matur­ing “video game gen­er­a­tion” as the skill-set for suc­cess in speed trad­ing is very sim­i­lar to what makes for a suc­cess­ful gamer.  As mar­kets tran­si­tioned from frac­tions to dec­i­mals and more vol­ume shifted to Elec­tronic Com­mu­ni­ca­tion Net­work Exchanges (ECNs), spreads nar­rowed sub­stan­tially.  In some ways, the suc­cess of day­traders at exe­cut­ing this strat­egy gen­er­ated its own demise.  It was still prac­ti­cal to trade spreads even after the tran­si­tion to the dec­i­mal sys­tem, yet as more traders enjoyed suc­cess, even more traders adopted the approach.  This increased the abun­dance of day­traders and fur­ther com­pressed spreads.  More­over it awak­ened larger insti­tu­tions to the immense amount of money being chis­eled away from their larger trans­ac­tions to the point where some devel­oped their own, faster elec­tronic trad­ing pro­grams, and oth­ers began frag­ment­ing orders into smaller pieces.
2. Order-Flow Traders. Traders were able to gauge an imbal­ance in order-flow based on access to level II quotes.  This allowed traders to read “the book” in order to seek out large bids or offers.  For years, and par­tic­u­larly dur­ing the volatile times of the finan­cial cri­sis, this afforded immense oppor­tu­nity with min­i­mal risk.  Some traders used this strat­egy to fol­low a stock’s momen­tum, while oth­ers used it to iden­tify tops and bot­toms based on dif­fer­ent read­able met­rics in the book of orders.  At its essence, order-flow recog­ni­tion relied on front-running much larger orders, and in the end, much like with “speed trad­ing” the larger insti­tu­tions rec­og­nized this fact.  This pro­vided one more rea­son for insti­tu­tions to frag­ment their large orders into much smaller pieces that are far more dif­fi­cult for day­traders to iden­tify.  More­over, with an abun­dance of com­puter vol­ume that is infi­nitely quicker than the human vari­ety, it’s more dif­fi­cult than ever to iden­tify what liq­uid­ity within the mar­ket is real and what is fake, thus mak­ing the strat­egy of order-flow recog­ni­tion a riskier one with less of an edge.
3. Sec­tor Rel­a­tive Strength/Weakness. This was by far my per­sonal favorite.  On my first day of train­ing, my trainer told us to mem­o­rize 5 names in 10 sec­tors. I took the leap to famil­iar­ize myself with 10 names in 20 sec­tors.   I also inher­ited a com­pre­hen­sive set of “bas­kets” which sorted stocks by their rela­tion­ships to one another. Over time I built these up to be even more thor­ough.  The key to this strat­egy relied on rec­og­niz­ing lead­ers and lag­gards within sec­tors (for exam­ple, when the agri­cul­ture stocks were strong and POT and AGU traded higher, one could just buy MOS) and also rec­og­niz­ing inter­re­la­tion­ships between sec­tors (like when the steel stocks were run­ning, the met­al­lur­gic coal stocks would fol­low shortly there­after).  The rise of ETFs and pro­grammed trad­ing killed this edge.  Now pro­gram­mers have cre­ated trad­ing algo­rithms to buy and sell ETFs and their com­po­nents off of rel­e­vant and related mar­ket fluc­tu­a­tions.  Com­put­ers are far quicker than humans, and as such, there is sim­ply lit­tle edge in the rel­a­tive strength/weakness trade anymore.
4. Inter­mar­ket Price Dis­crep­an­cies. This strat­egy is sim­i­lar to the relative/strength weak­ness out­lined above. How­ever, instead of trad­ing stocks off of one another, this looks at price fluc­tu­a­tions across mar­kets.  For exam­ple, if oil runs, traders could just buy the OIH, or one of its many com­po­nent stocks. Or, if cop­per drops, traders could sim­ply short FCX, a cop­per miner, in time to make a nice profit.  In some stretches, the rela­tion­ship between the dol­lar and equi­ties, or Trea­suries and equi­ties, offered oppor­tu­nity as well.  Yet once again, com­put­ers replaced humans in exploit­ing this edge, thus ren­der­ing the strat­egy ineffective.
5. Tech­ni­cal Analy­sis. This is per­haps the prover­bial “last man stand­ing” in the day trad­ing world and is the only one that has any sort of edge at the moment.  Tech­ni­cal analy­sis worked par­tic­u­larly well in 2007-09 as mar­kets were head­ing lower and mov­ing in an emo­tional frenzy of panic.  The emo­tions preva­lent in down­moves tend to lead to far more emo­tional price recog­ni­tion and a reliance on his­tor­i­cal lev­els that is some­what muted when mar­kets move to the upside.  Although tech­ni­cal analy­sis con­tin­ues to be rel­e­vant in some con­texts, it is far more suited as a tool in a trader’s arse­nal than a stand-alone trad­ing strat­egy.  More­over, com­put­ers started rec­og­niz­ing intra­day tech­ni­cal pat­terns and in doing so, pro­gram­mers began cloud­ing the impor­tance of intra­day lev­els.  Stocks that once moved rather smoothly from point A to point B now move in a more jagged and less pre­dictable man­ner.  This required tech­ni­cal traders to “step up a time­frame” and rather than trade on 1 or 5 minute charts, to focus on 15 minute, hourly and even daily charts.  Trad­ing higher time­frames requires a com­pletely dif­fer­ent approach to risk man­age­ment.  Both the risk and reward are greater, and as such selec­tiv­ity is nec­es­sary, expe­ri­ence and feel are far more rel­e­vant, and infor­ma­tion is power.  In the big­ger pic­ture, a “bear flag” at 52-week lows could eas­ily turn into a takeover tar­get at 52-week highs (Look at MFE for one such exam­ple) and a break­out to highs on vol­ume could eas­ily turn into the next earn­ings col­lapse. In order to sur­vive, it’s essen­tial to have a much more com­plex under­stand­ing of the com­pa­nies you trade and the macroclimate.

As you can see with the pop­u­lar strate­gies above, a fun­da­men­tal shift has taken place in the profession. In today’s mar­ket, traders now have to be both right about direc­tion and have con­vic­tion in the direc­tion at the same time. Traders must spend increas­ing amounts of time famil­iar­iz­ing them­selves with the fun­da­men­tals of the econ­omy and indi­vid­ual equities.

Per­haps most impor­tantly, the sur­viv­ing day­traders no longer trade solely on an intra­day basis. With 24/7 mar­kets and mas­sive overnight moves, it has become not just prof­itable but nec­es­sary to sur­vive through longer term trades.  The day traders left stand­ing are more anal­o­gous to hedge fund traders, and suc­cess­ful new day­traders are much harder to come by (i.e., a lot more Aver­age Joe’s are going to lose their money in a busi­ness where 90+% of the par­tic­i­pants are already losing).

Often times when some­thing becomes con­ven­tional wis­dom in the mar­ket is exactly when that some­thing quickly loses its pres­tige. For the past few years we have heard over and again that “buy and hold invest­ing is dead” and that “trad­ing” is the way of the future. Per­son­ally, I believe we are in the midst of the clas­sic exam­ple of rever­sion to the mean.

Over the past ten years, trad­ing was wildly suc­cess­ful rel­a­tive to buy and hold invest­ing. The pro­nounce­ment that this rela­tion­ship will con­tinue into the future seems to be com­ing from those who are now try­ing to train more than trade, or those who missed the boat and are attempt­ing to play catchup.

The evi­dence proves com­put­ers now own the short-term, but humans still own the long-term. Get­ting back to my con­ver­sa­tion with Justin Fox, over the past decade “price effi­ciency” ruled in cre­at­ing a sub­stan­tial oppor­tu­nity for traders.  In today’s mar­ket, earn­ings mul­ti­ples are so com­pressed that “value effi­ciency” cre­ates an equally great oppor­tu­nity for buy and hold investors.

The Proof is Everywhere

My evi­dence for the demise of day trad­ing is the hoards of peo­ple I know leav­ing the game, the shift of prof­its to HFT books, and the tran­si­tion trad­ing firms are mak­ing to become train­ing firms. If all of this is an illu­sion and day trad­ing still lives, sim­ply open the books to your dis­cre­tionary trad­ing desks and state your case below …

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Damien Hoffman, Esq. decided to launch a financial website and exclusive subscription-based newsletter after achieving a 63% return versus a -48% return for the S&P over a nearly two year time frame as a co-founder of popular stock blog SmartGuyStocks (member of the Forbes Business and Finance Blog Network, and certified by Seeking Alpha). Mr Hoffman is currently Editor-in-Chief of Wall St. Cheat Sheet and trades full-time. After graduating early with honors from Duke University, he raised private equity with friends during the late Nineties to launch a successful start-up. Mr. Hoffman went on to work for boutique sports investment bank Inner Circle LLP where he worked on the sale of the NBA franchise New Jersey Nets to Brooklyn real estate development firm Forest City Ratner Companies (NYSE: FCE-A). Mr. Hoffman also graduated with honors from the University of Miami School of Law as a Dean’s Merit Scholar. He clerked at the Florida Supreme Court for the Honorable Justice Kenneth Bell and Central Staff. In 2006 at Harvard Law School he gave a guest lecture entitled, “Business and Law in the New Independent Music Industry.” Read more from the author/contributor here.

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