Wednesday, June 21, 2006

Criticism of Daytrading Followup

"To play devil's advocate...if your test shows the tide is against daytraders and against investors. Is the tide with those brave souls willing to hold overnight and dump their holdings the next day? Hold short-term? Long-term? What criteria are you using to determine the tide is with if you trade like yourself? Are you adjusting your exits depending on certain conditions? Scaling out? If so, possibly daytraders and investors can and most likely are doing the same. Plus, your test is only showing one instrument. What happens if you choose a different one? What happens if you diversify across several instruments. Or diversify across time? I could go on and on. There are so many ways to skin this cat...that it's very hard to discount one methodology over another." -- Michael Taylor

This is a great subject for writing about because it is hard to pin down all the angles. I can't resist ;-) Rather than process of elimination, let's discuss some of the important factors that all market participants must deal with because no matter what strategy you use, they are a factor. Off the top of my head some important ones are:
  • commission
  • bid-ask spread
  • margin interest
  • taxes
  • slippage
  • gaps
  • dividends
  • money market interest
  • interest on short positions
  • dividends paid out for short positions

Every trader should have a good understanding of how these factors affect each of their strategies and tactics. I bolded the two that I feel are immediately relevant to my previous post regarding daytrading and "investing". Before I tear into these strategies again, let me say that each has their place for a well rounded and properly capitalized trader.

Most people have probably given some thought to whether or not they feel that market prices have an infinite fractal dimensionality or not. In otherwords, if I show you a chart of continuous prices I grabbed at random that doesn't have labels on the time axis and price axis, could you make a good guess about what time horizon and price range you were looking at? Could you do it repeatedly with any accuracy? For me, the answer is no. So I assume that daytraders in general are in fact trading the same kinds of chart patterns and price trends that I am, just on a different scale. The daytrader could employ twice as much leverage as I could, but he would also be paying the same bid-ask spread as I would have to. Regardless of how much leverage he chose to use, he's paying the spread on the whole thing, and when expressed as a percentage of his average profits, the bid-ask spread takes a ridiculously larger chunk of his profits using the same chart trading techniques! The daytrader also has a higher turnover, which means more chances for commission and slippage to eat into the profits.

"Ah," you might say, "but the daytrader could avoid the spread by using limit orders." That is correct, you can choose the time of your trade or the price of your trade, but the two are mutually exclusive. So our limit ordering daytrader can't even be sure that he will get the positions that his strategy requires him to have. Also, the best trades have a funny way of not quite getting to your limit anyway. There is no shortcut around the bid-ask spread that doesn't penalize you in another equally sinister way.

Let's not forget gaps. There is a mutually exclusive relationship to explore here as well, and it is all about liquidity. It is a fact that people will pay a premium to reduce their risk. If you can provide liquidity for these people and are good at selectively managing the risks involved, you will be paid a premium. Carrying stock positions overnight is one way of providing liquidity to people in aggregate. Any trader who's thought deeply about it understands that when he is successful in his trading operations, it just so happens that he has improved the liquidity of the market. He has bought when both supply was abundant and demand was scarce. He has sold when supply was both relatively scarce and demand relatively abundant. Buy uncertainty and sell hope.

All these things are the tide that I'm talking about. It is quite convenient that you can see it on the price series of the QQQQ. I'm not saying that you can't be successful daytrading because there are zillions of people who are, but they are grinding it out in an uphill battle for reasons that are fundamental to the way markets work. On top of that, daytrading takes a LOT of time that could be spent on things equally as gratifying. I like the easy road.


At 10:59 PM, Blogger Michael Taylor said...

Couldn't agree more. My point wasn't to say daytrading or investing was the way to go. Just that it can be done and some have done it very well. In fact, one of the main advantages to daytrading is trade frequency.

If you have an that exceeds all those "costs" you mentioned...even if it barely edges over that cost...the more times you use it the more money you will make. Naturally, the edge is smaller in daytrading than longer-term trading...but the frequency of trades is higher.

Of course, you mentioned the advantages to investors...the holders of risk and the longer you extend your holding period the less those costs eat away at your profits. But, because of the reduction in trade need a much larger edge than a daytrader would.

But, as an investor you do have the advantage of using very little capital to enjoy some extraordinary gains unlike the heavily marginalized daytraders. That's how that one investor I mentioned does it. He invests very little in each idea...but just needs one or two ideas in his lifetime to become rich. He hit the semi boom square on the head, followed it up with the fiber optics boom, and so far has enjoyed every last stinking cent of the oil & gas boom.

T. Boone Pickens is another one of these types of guys. Hell, who would have thought the dude would make a killing on oil & gas twice in a life time? Ha ha. Jim Rogers is another example of making a killing with commodities twice in a lifetime. The old saying is correct...even a broken clock is right twice a day.

So, which is better? Work your ass off every day watching the screen...worried you'll miss your next trade because of a potty break? Or kick back sipping a corona while on a beach without the least bit of worry about the market and your positions?

Me personally? I have chosen sipping coronas with the occasional glance at my positions on a weekly basis. But, the longer I trade and the more time spent testing ideas and systems...I lean towards extending that time period out further and further.

But, others will choose the daily grind and forego those potty breaks. Reminds me of a Jay Leno story about vacations here.

I had heard that Leno works hard. I had no idea how hard. He rarely takes a day off and has not taken a vacation in 20 years. When I ask him why, he tells a story. (Like many comedians, Leno deflects questions by going for a laugh.) He once had a gig in Hawaii, he says, and decided to spend a day on the beach. He sat there for what felt like hours and checked his watch. It said 10:10 A.M. "I thought the sun had broken my watch!" he says. "I'd only been there ten minutes!"

As always, more than one way to skin a cat. :)

Later Trades,


At 1:19 PM, Blogger Michael Taylor said...

Sorry, I meant margined instead of marginalized:

"But, as an investor you do have the advantage of using very little capital to enjoy some extraordinary gains unlike the heavily margined daytraders."

At 3:12 PM, Blogger mike said...

A comment and a question.

First, the article prior to this one you expressed a pretty good amount of frustration about blogging, etc. For what its worth I may not be vocal enough but have your blog as a regular read and enjoy it.

Second, I am relatively new to trading, started out thinking I'd be more position or swing trading and am sliding to a day trading mentality but your rationale and arguments for a longer period of interesting and I appreciate the info. The real question for me ends up being returns. Without asking for info that you may think is too personal, can you share a ballpark for the type of returns you make or think are possible using your approach?



At 7:29 PM, Anonymous Anonymous said...

Hi Jon,
Nice blog, hope you keep writing. I know you do not care for day trading but I felt the need to pipe in here for a sec. Bid-ask spread for most liquid stocks is only a few cents and if you are using a limit orders to buy and sell it does not really matter. If I place and order for 50.25 it gets filled, I sell at 50.50 it gets filled, both at my price. Slippage does not exist. Most of the time we do not hold overnight so we reduce our risk of Gaps, short dividends, halts etc. I am not saying one way is better or not, to each his own, simply pointing out some facts that should be out there.


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