How to Become Smarter (51 page)

You should not interpret the discussion above as an endorsement of day trading of stocks. My advice is to avoid this activity. Day trading involves much higher transaction costs relative to profits in comparison with position trading and speculation. Only a small minority of day traders (about 10-14%) can make a living and even fewer day traders can grow their trading account. Readers may consider the following questions before investing their savings in day trading. How do I know that I will be among the 10% or so of the successful day traders? Why do I think I will be better than other day traders? Some studies show that success in day trading does not correlate with any personality traits [
525
]. Thus, there is no personality profile that can help to predict success or failure. It is tempting for me to say that if you have a high IQ, you may be more likely to succeed at day trading. Research data that either support or refute this assumption are unavailable at present. (For example, IQ does not correlate with successful self-employment and with huge income [
24
,
519
].) Some day traders incur huge losses, in the hundreds of thousands of dollars, according to the studies above. Therefore, most people will do well to avoid this controversial activity.

As of this writing, there are no research data on day traders of financial instruments other than stocks. Therefore, it is unknown what percentage of day traders of forex or futures markets is profitable consistently if any. My guess is that day trading of forex (very popular lately) cannot bring consistent profits. This is because forex traders have too little information at their disposal compared to day traders of stocks. For one thing, forex traders do not see the volume of transactions—they only see the price chart of any given pair of currencies. Another thing is that the bid/ask spread is constant, which eliminates another piece of information about the market. Some forex dealers are also employing questionable tactics in attracting new clients.

Originally, some forex dealers/brokers claimed on their websites that trading of forex is commission-free, which is untrue, of course. Forex commissions are built into the currency spread (the difference between bid and ask price). Whenever you place an order, your account loses the amount of the spread times leverage that you use. Right now, this deceptive practice (the claim of commission-free trading) is uncommon. In addition, forex dealers are advertising high leverage as a great boon to traders. Some dealers used to offer trading with 400:1 leverage (before government regulators imposed leverage limits). What these dealers do not tell you is that leverage increases trading losses and the commissions that you pay. A single order placed with high leverage can cost you 10% of your account or more in commissions alone. To put this kind of losses into perspective, consider the inability of the majority of mutual fund managers to achieve better than 11%
annual
returns in the long run. In forex, you can lose 11% of your account in one minute in transaction costs alone. Also, high leverage (large bets) increases losses
more
than it does profits. For example, suppose you are risking 35% of your capital on each trade (you expect to either win 35% or lose 35%). In this case you will sustain a 12% loss if you win one trade and then lose another: 1.35 times 0.65 equals approximately 0.88.

Some forex dealers are advertising the “achievements” of their clients by conducting trading contests. For example, they may publish the lists of “winners” who achieved the best trading results within a given month. Some of these “winners” show returns of 300% per month or greater as a result of trading forex. Sounds great, doesn’t it? But don’t rush to sign up for an account with a forex dealer just yet. These results are only a part of the picture and you should not take them at face value. Since enormous returns require the use of gigantic leverage, these “winners” must have wiped out their whole account a number of times before hitting the jackpot. Let’s say somebody wipes out four times, each time depositing the same amount of money into the account, and then achieves a 300% return by chance. This strategy will result in a net loss of money. Another problem with these outsized returns is that winners are different each month, suggesting that randomness plays a substantial role in forex trading. If someone achieved a 300% return within one month, it is unlikely that they will be able to keep up this kind of performance in subsequent months. Most of these “winners” will wipe out their account in the subsequent months because: {a} the currency market is random and unpredictable (less information is available to traders compared to the stock market and technical analysis cannot work with position trading); {b} high leverage amplifies transaction costs and trading losses; and {c} high leverage is taxing psychologically and will impair rational analysis of market data. It would be helpful if some forex dealers published statistics of successful trading of their clients. For example, what percentage of clients is profitable over a 6-month or 1-year period? What is their average profit or return on investment? What is the average percentage loss for clients who are not profitable? These data can serve as a good risk disclosure for prospective forex traders.

As for research of profitability of position trading and speculation, there is little hard data in the literature. At present, there are no peer-reviewed studies on profitability of these longer-term traders who trade off the exchange floor. Just to remind you, we defined position trading as holding periods of 12 hours to one month and speculation one month to one year. One study examined profitability of different types of traders in the Taiwan futures market over a period of one year [
526
]. The researchers have found that individuals and futures dealers perform poorly on average, whereas security dealers and foreign investors earn significant profits. Foreign investors are the most profitable category of traders. The holding periods examined in this study were one day to five days. This report does not provide a cross-sectional analysis of profitability of the category of individual traders. It is possible that a certain percentage of lone traders are profitable consistently, just like with day trading, or that none of the individual traders earn consistent profits. Further research is needed.

It is possible that the percentage of successful position traders and speculators is much lower than the percentage of successful day-traders because:

1. In contrast to day trading, position trading and speculation are “easy” or almost effortless money. Therefore, these profits should be all but impossible in a competitive market.
   
2. Immediate future is more predictable than the distant future (news is unpredictable).
   
3. Profitability of position traders and speculators contradicts the efficient market hypothesis, whereas profitability of day traders does not.
   

There are well-documented accounts of successful speculators and position traders; curious readers can find them in books by Jack Schwager. It would be safe to say that these people are very rare.

The most successful financial speculators have shown long-term returns of 25-30% per year. Even a 16% average annual return is outstanding and people who can deliver this sort of investing results manage endowments of large private universities in the United States. People who are not members of an exchange and who want to become traders will not be able to make a living by trading if they start with $1,000 or even with $50,000. Living expenses and taxes will eat up all profits. There is also a risk that transaction costs and occasional catastrophic mistakes will wipe out the small account. Thus the trader will not see any consistent profits if he starts with small trading capital.

For these reasons, you can ignore mass-marketed trading systems. These systems often deal with the stock market, options, foreign exchange, and futures. In particular, avoid “advanced” seminars that cost several thousand dollars and promise you financial freedom for the rest of your life after you attend the seminar. Don’t buy automatic trading systems in a box (software) either, even if these products cost “only” a hundred bucks. It is still a waste of money. Don’t waste your time and money on books about technical analysis or books that promise to teach you how to make a living by trading in financial markets. Most of this information is available for free on the Internet and successful traders do not write books about their techniques. Some successful traders write books sometimes [
527
,
528
], but these books offer a
vague
discussion of the authors’ trading techniques.

The experience of the famous trader named Richard Dennis suggests that once you reveal your successful trading system to other market participants, the system will stop working. A trading system intended for the mass audience (in the form of books, videotapes, seminars, software, and so on) cannot be profitable for three reasons: 1) there are no willing losers in the markets; 2) the “crowd effect” or competition; and 3) the “secrecy principle.” The text below explains each reason in detail.

1)
  If a trading system is profitable and becomes known to many market participants, it will stop working. This is because the market participants who used to lose money to this system will stop making the same mistake over and over. Nobody wants to lose money in the markets.

2)
  When many participants start using the same trading technique, this strategy will stop being profitable. This is the “crowd effect.” You can make a profit if you buy low and sell high. When many people rush in to buy low, the price will rise and most people will not be able to buy at the low point. Similarly, if too many traders start selling at the high point, then the price will go down and most market participants will not be able to sell at the high point. In the end, most of the users of this trading strategy will break even at best. Successful short selling involves selling high followed by buying low, but the same “crowd effect” applies here as above. This principle is also applicable to financial derivatives. The crowd effect also applies to various self-improvement methods that are supposed to help you achieve “big success,” although the mechanism is different. You can achieve “big success” if you have a big advantage over other people (for example, a special talent that only one person in a million can have). Promoters of the “secrets of success” are trying to sell them to as many people as possible. A “secret of success” known to large numbers of people cannot help you to gain an advantage over these numerous “competitors.” The promoters are promising you a huge advantage over other people, but at the same time, they are trying to create as many competitors for you as possible. Therefore, the best you can hope for when you buy a mass-marketed secret of success is “small success” or no success at all. Besides, a person whose only achievement lies in teaching others how to achieve big success must be a fraud. When this person was starting out, he was teaching others what he could not do himself. “Fake it till you make it.”

At its basic level, the crowd effect is another word for economic competition. Seminars that cost one or two months’ worth of your salary may look like some type of “exclusive knowledge” unavailable to the masses. But they will not give you any edge over other people and will not provide you with access to easy money. For one thing, even if you have fifteen competitors (an audience of a seminar), your knowledge is no longer exclusive and no easy profits will be possible. Richard Dennis taught his profitable “turtle trading” system to fewer than fifteen people (he did it for free, on a bet with another successful trader) and his trading system stopped working several years later. Richard sustained huge losses in his own trading after this bet. On the other hand, unscrupulous “gurus” sell seminars to hundreds and thousands of people year after year. The easy money that the gurus promise is impossible when you have so many competitors. The providers of seminars will also have you sign various legal disclaimers. The latter will free the organizers of any liabilities in the event that you do not achieve what you are paying for: a quick and easy path to wealth. This alone should be a signal that the promoters are not trustworthy. The promoters can fake all testimonials and “success stories,” and you should not take them seriously, unless the promoters show you verifiable trading records. Even if a success story is true, it may be due to simple coincidence or dumb luck or may be a part of a larger failure. If “success” happened after someone attended a seminar, this does not necessarily mean that the seminar is the cause of the success. Academic degrees from prestigious institutions and celebrity endorsements do not mean that the promoters are honest people. Celebrities can make mistakes and there is a certain percentage of crooks and criminals among graduates of any university. When you see someone using celebrity endorsements in their advertising of health-, mental health-, “success-,” or “wealth-building”-related products, this is a big red flag. This usually means that there is no scientific evidence of effectiveness, and a “guru” is offering you an overpriced and useless product or service, i.e. snake oil. Chapter One discusses evaluation of the strength of evidence. In summary, competition will ensure that a “secret of easy wealth” will stop working if it becomes known to just a few people, not to mention thousands of people.

3)
  From the crowd effect follows the related “secrecy principle:” if a trading system were profitable, then the author(s) would be using it for their own profit instead of revealing it to other market participants. We can prove this principle as follows. If the trading system is profitable, then the inventor can grow the profits by reinvesting them into the system and increasing the size of her transactions. The inventor can also increase her profits by investing other people’s money and charging fees for money management. The growth of profits will be possible until large transactions start to affect the price of the financial instrument. After that, the profits will stop growing. In other words, at some point, the sheer size of an order placed by the inventor of the system will be driving the price up (buy order) or down (sell order). This will make the trade either unprofitable or barely profitable. At this point, we will assume that nobody knows about the details of this profitable trading system except the inventor. As you can see, it makes no sense for the inventor to sell her profitable secret to the public at the early stage, when further growth of profits is possible. It also makes little sense for her to sell the secret to the public when the profits have plateaued. Why risk losing the gravy train for the sake of the uncertain profits that may come from selling the system to the public? What if the proceeds from the sale of the system (as software, videotapes, or books) will be much smaller than the current profits? After all, the market is flooded with get-rich-quick books and books about trading. The existing profits will disappear once other traders start using this system (the crowd effect). Thus, it will be more reasonable to continue to receive profits from the system and to keep it secret (the secrecy principle).