The Shaky Logic of Day-Trading

Here's a good question for you: If most people who day trade lose much or all of their money, why would anyone sane ever do it?

There are, of course, a bunch of possible explanations. For starters, some people just don't realize how hard successful day-trading can be, and how slim their chances of success are. Then there's the old reliable culprit: greed. You might know that the odds are against you, but like a lottery player, you want to go for it anyway ... just in case.

Another reason is overconfidence. The research of finance professors Terrance Odean, Brad Barber, and Simon Gervais has linked overconfidence to frequent trading, and frequent trading to diminished investment returns. They suggest that traders tend to give themselves more credit for successful trades than for unsuccessful ones, and thereby become overconfident. (People also tend to dwell on investing successes more than on than blunders. Read more about all of this.)

Desperation might be at work, too. Once you've lost most of your money, you might frantically trade with what's left, in an attempt to recover your losses. A grisly scenario, no?

The survey says ...
Meanwhile, lest you get tempted to try it, here are some stats and quips:

  • A study a few years ago by the North American Securities Administrators Association suggested that about three in 10 day traders might trade profitably. Of course, trading "profitably" does not even mean that they will beat the S&P 500. That performance is available at a very low cost, through the purchase of an index fund.
  • According to managers of day-trading firms cited in a Washington Post Magazine article that I read a bunch of years ago, about 90% of day traders "are washed up within three months."
  • David Shellenberger of the Massachusetts Securities Division has noted that "Most traders will lose all of their money."
  • A principal of a day-trading firm even admitted that "95% [of day traders] will fail in the first two years."
  • Former Securities and Exchange Commission Chairman Arthur Levitt has recommended that people day trade only with "money they can afford to lose."

So if all of these people lose money doing it, who's making money with day trading? The brokerages and companies that service day traders, for one. Imagine making $3 to $5 each time someone trades. If they trade, say, 50 times per day, that's $150 to $250 per day, $750 to $1,250 per week, and $39,000 to $65,000 per year -- from one trader.

Fortunately, here at the Fool, we tend to prefer decade-trading to day-trading.

Keep in mind
Of course, remember that just because you may trade stocks online, that doesn't make you a day-trader, as long as you trade relatively infrequently. Accessing brokerages online makes sense for most people, especially when commissions for online trades can be much lower -- such as $5 or less per trade. Learn more in our Broker Center, which also features a handy brokerage-comparison chart. E*Trade (Nasdaq: ETFC  ) , Fidelity, TD AMERITRADE (Nasdaq: AMTD  ) and ShareBuilder, for example, all offer commission rates of less than $10, while Scottrade and Firstrade, among many others, charge around $7 or less.

Learn more about day-trading by checking out the SEC website and the FTC website.

Longtime Fool contributor Selena Maranjian doesn't own shares of the companies mentioned in this article. Try any one of our investing services free for 30 days. The Motley Fool isFools writing for Fools.


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