a must read research paper for all day traders

detailed excerpts from research paper submitted by

Brad M. Barber (University of California) &

Yi-Tsung Lee & Yu-Jane Liu (National Chengchi University Taipei)

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Most day traders, especially heavy day traders, lose money trading.

Why do investors engage in such a wealth reducing activity?

One possibility is that investors simply find day trading entertaining.

Undoubtedly some investors do find day trading entertaining, but can entertainment account for the extent of day trading that we observe?

Do day traders knowingly and willingly accept such large expected losses for fun?

For all but the wealthiest investors, this would be a very expensive form of entertainment indeed.

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Another reason why day trading might entice investors would be if it provided an appealing distribution of returns.

People often display an attraction to highly skewed investments, such as lotteries, that have negative expected returns but a small probability of a large payoff.

However, the day trading profits that we document are similar in magnitude to, and far less prevalent than, losses.

Unlike lottery winners, day traders must succeed on repeated gambles in order to achieve overall success.

Such repeated gambles do not tend to generate highly skewed distributions.

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A final potential explanation for the prevalence of day trading is that most day traders are overconfident about their own chances of success.

Several papers argue that overconfidence causes investors to trade more than is in their own best interest.

Overconfident day traders may simply be bearing losses that they did not anticipate.

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While day traders undoubtedly realize that other day traders lose money, stories of successful day traders may circulate in non-representative proportions, thus giving the impression that success is more frequent that it is.

Heavy day traders, who earn gross profits but net losses, may not fully consider trading costs when assessing their own ability.

And, individual day traders may believe themselves more likely to succeed than the average day trader.

We are unable to explicitly test whether day traders are motivated by overconfidence rather than the desire for entertainment.

Our opinion is that the average losses incurred by day traders are more than most would willingly accept as the cost of entertainment and that, by and large, day traders must hold unrealistic beliefs about their chances of success.

We find that the trades of heavy day traders are profitable before deducting transactions costs and that the trades of previously successful traders are profitable even after accounting for costs.

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Conclusion

About one percent of individual investors account for half of day trading and one fourth of total individual investor trading volume. Our analysis of performance indicates day trading is treacherous, but not entirely a fool’s game.
Over the typical six month horizon, using lower range assumptions regarding transaction costs, less than 20 percent of day traders earn profits net of transaction costs.

These results paint a rather dim portrait of day traders. However, we do document a select few are able to consistently earn profits sufficient to cover transaction costs.

We identify day traders who earn substantial profits over a six-month period and analyze the performance of their subsequent trades. These profitable day traders continue to earn stellar returns.

There is strong evidence of persistence in the ability of day traders. Our analysis makes clear the need for comprehensive risk disclosure. Prospective day traders should be apprised of their likelihood of success: only two out of ten make money; fewer do so consistently.