With the rapid growth of the Internet in the late 1990s, international stock markets moved online and became easily accessible to anyone with access to the World Wide Web. As a result, people were able to trade stocks directly from their own computers, a function previously performed only by stock brokers. Once people realized they could handle their own stock trades, many decided to try to make money by guessing when the ups and downs in the stock market would occur. As a result, day trading was born. The effect that the Internet has had on the stock markets cannot be emphasized enough. Commenting in Entrepreneur, Securities and Exchange Commission (SEC) Chairman Arthur Levitt estimated that in 1999, 2 5 percent of all trades were made by individuals online. That means that seven million investors participated in online trading—which is impressive considering there were none just five years earlier. And more growth is expected.
In its investigation of the new practice, the U.S. Senate Permanent Subcommittee on Investigations defined day trading as "placing multiple buy and sell orders for securities and holding positions for a very short period of time, usually minutes or a few hours, but rarely longer than a day. Day traders seek profits in small increments from momentary fluctuations in stock prices after paying commissions." In the more technical language of the National Association of Securities Dealers (NASD), day trading is "an overall trading strategy characterized by the regular transmission by a customer of intra-day orders to effect both purchase and sale transactions in the same security or securities."
THE RISKS OF DAY TRADING
Basically, day trading firms differ from traditional brokerage houses, and even online brokerage companies, in one fundamental way—they offer their customers direct, electronic access to stock markets. A handful even offer real-time access, which means traders see the market just as it really is at that second. Traditional brokerages work with the customer, then place the trade orders through middlemen, called market makers. The customer is never involved directly in the trade, and it takes some time for the trade to be completed. Not so with day trading—the customer is actively involved, and trades are completed immediately. With nearly 2 million people making up to 100 stock trades per year, and 250,000 people making more than 400 trades annually, there is a large, and growing, market for the day trading firms to work with. The firms target the investors who make the most trades. Since trades can cost anywhere from $15 to $25 per trade, the day trading firm makes more money as an investor makes more trades, no matter what happens to the customer's stock. The customer can lose money, but the firm can never lose, thanks to the per trade fee.
With its "get rich quick" aura and seeming simplicity, day trading took the securities world by storm in the late 1990s. Everyone from professional stock brokers to the average Joe on the street tried to become a millionaire when stock markets soared at the end of the twentieth century. More than 100 companies provided day trading services in 2000, ranging from long-time brokers such as Charles Schwab to dot.com companies that were gone in a month. Although the total number of day traders is still only a fraction of the total number of people who invest in the stock market, James Lee of the ETA estimates that the actions of day traders may account for 10 to 15 percent of the total daily dollar volume on the Nasdaq stock exchange on any given day. In addition to being a different type of investor, the people involved in day trading treat stocks a different way. In the past, according to Fortune, the average length of time a stock share was held by an investor was two years; today, it's five months.
One of the key differences between day trading and regular stock investing is the knowledge required. In regular investing, stock brokers and others who invest spend days, even weeks, studying a particular company and learning all there is to know about it. Brokers will devote a career to one particular market segment, such as technology stocks, and much of their time is spent learning about the companies in that segment. When a regular investor makes a stock purchase, it is likely because he or she is knowledgeable about a company and expects its stock to do well in the long run—the next year to the next 20 years, perhaps.
In day trading, the investor often knows literally nothing about the companies that he or she is purchasing. "Who cares what [a company's] earnings are?" said Charles Kim of the day trading firm Swift Trade Securities in Canadian Business. "We don't." All the day trader knows is that there is some piece of information (or, often, a hunch) that has become available very recently that indicates that a certain company's stock is about to go up in the next minute, hour, or day. The day trader then purchases that stock, holds on to it until a suitable profit has been made (or, disastrously, money has been lost), then sells it. Stocks are rarely held overnight. Nothing is ever known about the company that was just traded. Essentially the day trader is gambling, betting that the next short-term price fluctuation will be in his or her favor and result in a profit.
As long as stocks were doing well, day trading was a popular, money-making activity for many people, or so it seemed. A 2000 study by the North American Securities Administrators Association, quoted in Forbes, found that "77 percent of day traders lose money. And of those who did profit, the average was just $22,000 over the space of eight months. Of the 124 accounts surveyed, only two—people, not percent—netted $100,000 or better. The highest was $160,000." And that was at a time (1998-1999) when the stock market was soaring. Now that it has come back down, there is even less money being made.
Because the real profits from day trading do not necessarily match the profits that some firms boast of in their advertisements, companies in the industry are closely scrutinized. NASD Regulation, Inc., the regulatory arm of NASD that polices the securities industry, studied 22 day trading firms in 1999 and came up with some disturbing conclusions. They found improprieties in "advertising, Regulation T and margin lending, registration of individuals, short sales, and supervision." As of early 2001, however, NASDR had only formally punished one day trading firm, fining it $25,000 for failing to properly train and certify the 14 individuals it had working as traders. Other agencies, such as the New York Stock Exchange, have begun to take action against unscrupulous day trading firms as well, and more action is expected. Several states have also conducted their own investigations of day trading firms within their borders and have taken enforcement actions against the worst offenders. However, the biggest risk to investors still seems to be simply losing money in the highly volatile stock market.
THE HISTORY OF DAY TRADING
Day trading has its origins in the birth of the computerized, over-the-counter NASD, which occurred in 1971. Fourteen years later, NASD created the Small-Order Execution System, which made it easy for individuals to execute stock trades automatically, as long as the orders were for 1,000 shares or less. Trades placed through SOES, as the system is known, bypassed the phone lines used to make most trades and placed orders in a matter of seconds, instead of minutes. While SOES users may not buy or sell the same stock during a five-minute period, there were still a group of daring investors who thought they could use SOES to make rapid stock transactions to make a great deal of money, and thus day trading was born.
The modern day trader is no longer limited to SOES. Indeed, the most popular tool for the day trader today is the electronic communication networks, or ECNs, which are internal networks set up to handle groups of customers who make large blocks of stock trades. All the members of one ECN may trade directly with other members of their network, placing buy or sell orders electronically. This has become the main tool of the day trader. To best use that tool, day traders watch the Nasdaq Level II screen religiously on their computers. The best bid on any given stock is displayed on the Nasdaq Level I screen, while the Level II screen displays all bid prices for a selected stock. This increased amount of information allows the trader to better gauge what is happening with the stock: What are the high and low bids? How many bids have been made? Are the number of bids increasing or decreasing? This information is invaluable as the day trader decides which stock to buy.
With the growth of any money-making activity comes the hangers-on, and that is true for day trading as well. There is a large industry that relies on day traders, from book and newsletter publishers to online advice columns and investment advisors. There are also training programs, on-site seminars, software, stock picking systems, and much more. All of these related industries are unregulated and full of hype, shady deals, and bad advice. It is definitely a "buyer beware" situation, but that fits in well with day trading in general.