I got a special invitation yesterday for a seminar that promised to teach me how to make money trading in the stock market. I was excited for a moment, until I realized that anyone else who was channel-surfing between the West Virginia football game and the local weather forecast got the same invitation. Nevertheless, the infomercial caught my eye, and I listened to the stories of ordinary people who'd never invested before making hundreds or even thousands of dollars trading stocks.
My general rule about money-making opportunities on infomercials is that if one person is making real money using a TV strategy, then there are probably a dozen or so who end up not making a penny or even losing money. When it comes to trading stocks, there are plenty of reasons why excessive trading can burn a hole in your portfolio's performance.
The rewards of winning
Many investors dream of being able to treat the stock market like a cash machine, buying a stock in the morning, waiting for it to go up, and then selling it for a nice profit in time for an afternoon cup of tea. Indeed, the rewards of making a good stock trade are immediate and can be substantial.
However, even when you make a winning trade, you're not the only one who benefits from your prowess. Say, for example, that you thought the Nasdaq would have a good day and therefore decided to buy 2,000 shares of the Nasdaq 100 Trust (Nasdaq: QQQQ ) . With fortuitous timing, there are numerous occasions on which you could have waited for the share price to rise $0.50 and then sold your position later in the same trading day, making a gross profit of $1,000.
You wouldn't have gotten to keep the whole $1,000 though. Your broker would have demanded commissions for both the purchase and the sale orders; even with a discount broker, you could expect to pay $20 or more for those trades. Also, although you wouldn't know about it, the IRS would be smiling at your trading success, knowing that it would eventually reap the benefits of your quick profits by levying taxes on your $1,000 gain. The same-day trades would subject your profits to short-term capital gains rates up to 35%. If you live in a state that has a state income tax, then your tax bill would be even higher. For some investors, it's conceivable that you might only get to keep half of your profits from this successful quick trade.
The perils of losing
The example discussed above is close to the best-case scenario for someone using a trading strategy. The mistake that many beginning investors make is that they use strategies that don't cover all situations. For instance, they might know exactly what to do if their QQQQ shares go up $0.50, but if the stock goes down, or even if it doesn't go up the full $0.50 before the end of the trading day, they may not have guidance on what action to take.
As a frequent trader, there are a number of different rules you can use when trades don't go your way. Many traders avoid holding positions in stocks overnight, in part because they fear news items that can easily lead to big adverse moves in the stock's price when it opens for trading the next day. On losing trades, many traders place stop-loss orders that automatically close out the position when the stock price crosses a certain threshold. However, placing stop-loss orders presents a dilemma to traders. If they set their stop-loss at a level too close to the current price, then they risk closing their position right before the stock takes off. However, if they set stop-losses too far below the current stock price, then it could cost them a lot more money for each losing trade. Emotionally, it's a lot easier to sell your winners and book the corresponding profit than it is to admit that you've made a mistake and lock in a loss. As a result, traders can fall into a pattern that plagues compulsive gamblers, hoping that adverse circumstances will reverse themselves and allow them to avoid having to close a position at a loss. Sometimes this works, but other times it can lead to even greater losses.
Furthermore, although losses on positions can be used to offset gains for tax purposes, you'll still pay those commissions, win or lose. Because you're constantly paying commissions, you need to make more money from your winning trades than you lose on your losing trades just to break even after costs.
What could have been
Perhaps most painfully, many successful quick trading opportunities result from stocks that perform even better as long-term holdings. For instance, you could have traded in and out of the Vanguard Total Stock Index ETF (AMEX: VTI ) on many occasions over the past four months for substantial profits. However, simply buying and holding the shares from the ETF's July lows would have resulted in a gain of over 10%. Traders of long-term winners like Google (Nasdaq: GOOG ) and Chicago Mercantile (NYSE: CME ) often end up picking off just a few dollars of gain from stocks that provide much greater returns to those with the patience to hold them over longer periods of time. Even those who follow strategies based on technical analysis often advise following long-term trends rather than taking short-term profits.
Frequent trading is a tempting strategy that provides immediate feedback and holds the promise of easy money. Over the long run, however, only the most astute traders can overcome the headwinds of higher costs and the need for extraordinary discipline. By investing on a longer timeframe, you can minimize trading costs and potentially reap far more from successful companies.
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Fool contributor Dan Caplinger once made a couple hundred bucks back in the 1990s trading AOL options, but his friend did a lot better just buying the stock. He doesn't own shares of the companies and funds mentioned in this article. The Fool's disclosure policy is always a winner.