The problem with day trading, an expert on financial markets says, is that few people bother to learn the rules first. college roommate, half a century ago, was a lean, athletic young man who cared about sports in mind as well as in body. He could tell you the batting averages of the 20 leading hitters for the last 20 years, or cite such arcane facts as the name (and the time) of the man who came in third in the Wanamaker Mile at the Millrose Games in 1935.
When he finished college, he went to work at a Wall Street firm that knew how to use his talents: He became a tape reader. If you gave him the symbol for any of some hundreds of stocks, he could tell you how often two upticks in its price produced a third uptick or a downtick the next time the stock traded at a different price. He sat in a cell of a room on Wall Street, the physical ticker tape scrolling through his hands. Ideally, he had no position when he came to work and none when he went home. But every day he made millions of dollars of purchases and sales and over the year a noticeable contribution to the profits of his firm.
Ordinary people couldn't hope to compete with my friend, quite apart from his extraordinary personal storage and retrieval capacities. Those were days when fixed commissions cost outsiders 1 to 1.5 percent of every trade, with no volume discounts. And the spread between bid and asked was normally half a point; the outsider bought at the top of the spread and sold at the bottom. Fees, spreads, and commissions would eat traders alive even if they got their markets right.
But my friend's trading imposed virtually no costs on his firm. All he had to do was get it right more often than not. And there's no question that different stocks, because they draw different sorts of people as followers, have different short-term activity patterns.
There was also another kind of trading, which tried to find price movements that might last for several days or even weeks. This, too, was best done by members on the floor of an exchange-indeed, the Securities and Exchange commission had occasional fits about "floor traders." Only a handful of these traders were left in the 1950s. I asked one of them what he did for a living: "I listen for the streetcar," he said. "When I hear it coming, I get on; when it seems to be slowing down, I get off." Outsiders had the handicap that they weren't on the streetcar's route.
The chance ordinary people had to play these games profitably opened up first in Chicago in the 1960s, when the commodities markets began to clean up what had been a pretty dubious act. People could buy their way in for a few tens of thousands of dollars, and stand in a trading pit, "spreading" the price of corn against the price of hogs, or June contracts against September contracts, "scalping" the short-term movements in the prices of contracts-first for the prices of agricultural commodities and then, with a whoosh, for currencies and interest-rate futures and all sorts of financial commodities. Because relatively small sums of money could control relatively large purchases and sales in the low-margin world of the commodities markets, outsiders were not so severely handicapped as the visitors to brokerage offices.
Very recently, trading as a business has been democratized. Today, anybody with a computer and a modem can buy a service that delivers up-to-the-minute detailed information about trades and prices in markets all over the world. One such service, MarketWatch.com, went public in January with a prospectus claiming 2.2 million hits per month on its Website-and the price of the stock more than quintupled in the first day of trading. The cable networks run commercials all day from brokers offering to execute transactions at commission rates measured in tenths of a percent of the value of the trade.
Much Internet "trading" is performed by people who have a barber who's plugged in to technology or a brother-in-law who lives near San Jose and keeps a keen ear open at cocktail parties. Buying stocks on the basis of tips or comments in chat rooms is like betting on the advice of touts at the racetracks: It's not a business, and over time it's not going to be profitable. Even for people who know what they're doing, cyberstreets are not paved with gold. The vigorish is still with the house, and the electronic customer, like his ancestor who hung around at the broker's office, still buys at the asked and sells at the bid. But in actively traded stocks the spread may be as little as a sixteenth of a point, or six and one quarter cents a share, a manageable handicap.
The first rule for success in the trading world is to take the work seriously, to concentrate as hard as my roommate concentrated on his tape. Leo Melamed, who invented the first financial futures contracts, remembered that as long as he continued to practice law on the side, he lost money as a trader. This was and is a business of numbers and psychology, not economics: You have to live the numbers and practice the psychology. The trader's be-all and end-all is the most recent movement of prices in the markets-not just his one market, but many others: The walls of the rooms that hold the giant trading floors are covered with lights telling traders what's happening in the world's major markets for all the big commodities and financial instruments. If you're trading, say, interest-rate futures, you'd better keep abreast of what's happening in oil and gold.
The second rule, then, offered to novice commodity traders in a lecture by Charles DiFrancesca, is to know why you take positions, why you hold them, and why you sell them. DiFrancesca, whose advice is transcribed in William Falloon's book Charlie D.: The Story of the Legendary Bond Trader (Wiley), was the most admired independent bond trader in the busiest pit in the world. He thought the best discipline for young traders was "spreading"-taking long positions in one contract against short positions in another, to exploit changes in relative prices that would disappear as normal patterns reasserted themselves.
Once a trader was fairly consistently profitable in this low-margin business, he was more likely to succeed at the trickier business of "scalping," taking positions in one contract to catch brief waves of motion. The legacy of spreading was that traders should always have a reason for what they did. "If you're standing in the pit like a nail," he told the novices, "you don't have a reason for everything you do. Rely on your outside crutches as a scalper who spreads price relationships and imbalances that you see developing inside and outside the pit."
But those outside crutches, those reasons, are there only to prevent aimless activity. Like every trader, DiFrancesca agreed with the notion that good traders have to take their losses, quickly, and cannot ask Divine Providence to bail them out: "The people who survive at the Board of Trade have a low puke point....God doesn't trade bonds....He doesn't care what kind of trouble you're in; He doesn't trade bonds. You want to throw those future contracts up all over your shoes....There has to be a feeling inside of you that won't let you stay with something too long."
Human nature leads people to deny their mistakes. Even traders may acquire a crazy kind of loyalty to the positions they have taken, especially if they've talked to friends and neighbors about them. Television's Adam Smith likes to remind people that "the stock doesn't know you own it." If you scratch a money-losing trader, you are all but certain to find that he tries to cut his losses by hanging on until the stock or the commodity "comes back."
By the same token, traders find it hard to resist taking profits too fast. One of the most successful big traders in the currency and interest-rate markets says that he expects that 70 percent of his trades will be losers. But when he loses he loses small, and when he wins he wins big. Others who work in his trading room will say that they are profitable on 70 percent of their trades-but most of them lose money, because they grab for small winnings.
In the current lingo of the business, the two different species of trader are those that "sell volatility" and those that "buy volatility." My college friend sold volatility-that is, his essential bet was that market prices wouldn't move much, which meant he could always reverse his trades when he wanted to do so. All the hedge funds that claim to be market neutral-they can make money whichever way the market goes because they are betting on anomalies-are sellers of volatility and rely on a lot of liquidity in the market. This includes the infamous Long-Term Capital Management, which last fall had to be rescued from destruction. And, at the extreme, Nick Leeson of Barings, who sold out-of-the-money puts and calls on Japanese stocks, leaving him a little cash to put in his pockets if the markets didn't move much and a big hole in Barings's capital if they did.
These are the descendants of the classic Wall Street stock trader, the "contrarian" who assumed that the public was usually wrong, that most of the price movement in the market was noise, and that one could make money by selling on small rises and buying on small dips. Even more than other traders, the seller of volatility needs a talent for smelling when to head for the hills. George Soros said recently that he thought the LTCM "convergence" strategy would work 99.9 percent of the time, which was very generous of him, but even on those terms it's easy to be a loser. If you make a few bucks every day for 999 days and lose millions on the thousandth day, you will leave your children memories rather than estates.
Those who expect to overwhelm frequent small losses with less frequent large winnings come from a different school. They "buy volatility." Far from adopting a contrarian position, they take as their motto the old line from the Chicago pits, that "the trend is your friend." This is still trading, not investing. Buyers of volatility couldn't care less about the future earnings stream or purchasing power associated with what they buy: Such factors, presumably, are already in the price. The best of them are often ready for crises, because they limit their downside with something in the nature of "stop loss" orders, which in the modern world may mean fancy schemes for dynamic hedging.
These days, one can buy computer programs that purport to flag opportunities for short-term trading profits. They are useful for practice, like the programs that teach you card games, but following a strategy that's for sale to everybody is not likely to tap into an income-producing spread. There is no aptitude test for trading-the successful traders I know come from all sorts of backgrounds, from the most rarefied academic specialties to the jock worlds.
It's not socially responsible to encourage people to try their hand at trading. Just as the worst thing that can happen to an adolescent is to win big on that first visit to the racetrack or the casino, a profitable first month as a trader is a real danger. It's only after you've had a few bloody noses and moved on that you begin to understand what you're doing. Still, traders love what they do, though only a minority of them prosper; and technology has made it possible for almost anyone to try.
