While 2020 has introduced the world to the wonders of Zoom calls and baking sourdough, a much more nefarious new national pastime has entered our shared consciousness: day trading.
Day trading is quite literally what it sounds like. Well not trading Pokemon cards, but stocks more specifically. While the world has been hurting with Coronavirus, the stock markets have embraced a massive wave of new retail investors hoping to catch a money wave with trading apps.
Why did people suddenly decide to do such a seemingly random and esoteric thing? People have looked into it, and it’s mostly a combination of being bored at home and the availability of free*** stock trading apps. After all, one can only rewatch Nailed It so many times. Oh, and stimulus checks. Coincidentally, most new brokerage accounts opened to match the exact sum of the checks the U.S. government sent out to people to help with food. So, while 14 million children are in hunger in America, regular folks decided to gamble it away instead.
But doesn’t the economy suck?
Yes, it does. 99% of businesses do not benefit from a global lockdown. Millions have lost jobs, and many industries including travel & tourism are left for dead in the wake of the pandemic with little hope of recovery.
So why have stocks been going up since the pandemic started? Well, in the short-term stock prices are mostly determined by supply and demand. If there are willing buyers, the prices will keep going up despite any other facts. Early on, speculation was that the new retail investors were moving markets, but that seems doubtful. Early on, the government stepped by injecting billions into the markets trying to resuscitate the markets to avoid total economic collapse.
Recently, it turns out even large corporations have gotten into day trading. The Japanese giant Softbank bought billions in U.S. tech stocks in the last few months, with exposure of up to $50 billion and has now been sitting on $4 billion of profits from it. These kinds of volumes will move markets, especially as large options contracts force underlying purchases of those stocks by market makers.
The expectation and reality of Day trading
After an initial negative response to the pandemic, the U.S. markets have gone up and only up. Well, since last week that is. Social media is full of self-proclaimed market-beaters, who have it figured out. They have the screenshots to prove it! You just give them your money or pay them for tips, and you too can be rich super quick and almost guaranteed. At least, that’s what the Instagram bots are saying in their gushing referrals.
So how does it work? You just buy something and wait until the price goes up? Well, that is one strategy. Of course, you can also buy more stock than you can afford. What? Yeah, it’s like a credit card, but in finance, it’s called margin. So if you cash in your $1,000 stimulus check, an honest broker will allow you to trade more. Depending on the broker and what type of product you trade, that can be anywhere from $10,000 to $100,000. Yes, with just a thousand bucks.
Of course, the catch is that while you benefit from any gains in leverage, you also get decimated with leverage if prices go down. In fact, if you leveraged 1:10, then the prices need to go down just 10% for you to have lost all your money. And believe me, when I say, you CAN lose more than your account value! Yes, in fact, a 20-year-old kid committed suicide after the Robinhood falsely showed a leveraged loss of -$730,165 with an account that had just $17,000 in it. It’s all fun and games while you’re winning. Which usually isn’t very long at all.
The stats on regular folks aren’t good. Of course, there’s that one Japanese guy who made $153 million starting from just $13,600. But for one of those guys, you have 99% who lose money trading. Yes, 99%. While he’s unlikely to get many tears of sympathy, Japanese billionaire Maezawa, yeah the guy who’s funding Elon’s Moon adventure, said he lost a measly $41 million recently in trying his hand at day trading.
You know the saying “you don’t play boxing”? Well, the same goes for day trading. Think of day trading like surfing. Sure, it has a learning curve, but anyone can do it. But then add sharks. 20-foot Great Whites. There are no safe waters in day trading. You are playing chess against Garry Kasparov and Deep Blue without realizing it. It’s like accidentally stumbling into an online poker room with Phil Ivey. They will make you feel just comfortable enough to get you to bet big. Then they take all your money before you realize what happened.
Behind the anonymous veil of stock exchanges, there are thousands of sharks happy to steal your food before you even smell it. Even worse, 80% of trades are automated by algorithms. Robot sharks. They pay millions just to access data you don’t have, with teams of Harvard and MIT graduates doing analysis around the clock, just so they can bring a gun to the knife fight. They have no remorse either because they don’t see the damage. They’re just doing a job, too.
From trading to investing
So what’s the difference? If pension funds and governments are also buying stocks, what’s the harm? Warren Buffet buys stocks too, right? Why can’t I be like Warren?
Here’s a visualization for you. Let’s just look at the performance of the popular SPY ETF which follows the 500 biggest stocks in America (S&P 500). It just means that if you buy SPY you don’t need the hassle of buying 500 stocks separately, that’s all.
There’s a few conclusions you can draw from this, depending on how much you know about math and finance. A really simple one is this: stocks always go up in the long run, but it looks pretty random in the short term. So let’s examine both cases.
Why stocks go up at all
So fundamentally the question is who determines the price. Why should the price always go up? Well, professional investors, unlike you, are looking for a return for their money. No, not through the price, but dividends. You know how people say they work for “the man”? That man is the shareholder. You can be that man, too. When you work at a job, say consulting at a big firm, they pay you a nice salary. But of course, they only keep you in a job as long as the company can extract surplus value from you. Sorry, my inner Marxist gets excited sometimes. To keep it simple, the company makes more money from your work than they pay you. Where does that extra money go? Employee pension schemes, a free kombucha tap, and pizza buffet on Fridays? No, it goes to the shareholders. By the truckload.
So as long as the professional investors like Warren Buffet get paid their dividends every year, things are nice and stable. Companies like Coca-Cola, Johnson & Johnson, and even Apple do that consistently every year without exception. That’s why Warren likes those companies a lot. So if the economic environment is positive, and the companies grow, they pay even more dividends. More investors will want those sweet dividends and are willing to pay a higher premium to get those juicy checks every year. That’s why the most common way to value a stock is the ratio of price to earnings (from which they pay dividends), also called the P/E ratio.
This equation holds true and will drive prices up as long as those companies sell more products at higher margins. Coca-Cola used to cost a nickel, which is five U.S. cents. In fact, this price was fixed from 1886 to 1959. After that, the cost of inflation from economic growth has forced Coca-Cola to increase prices steadily. Today, in most countries, a bottle costs around two dollars. Doesn’t sound like much, but that’s an increase of 4,000%! Why? Well, because inflation. Things cost more over time because governments keep printing new money every year to keep the economy going. Luckily, during that same time period, the S&P 500 has gone up 34,490% (with dividends reinvested). Yes, you read that right. So if you want to afford a cube of Coke, or whatever they serve people/aliens in 2100, you’d better start investing today!
Why stocks are random in short-term
Without getting too nerdy on you, which is considering something given we’re talking about trading stocks, the price movements cannot be known. What do I mean? Surely somebody knows? Nope. Let me elaborate a little.
The stock markets are known as an incomplete information problem. Even if you are yourself Elon Musk (hi Elon, big fan!), you have a lot of information about the stock price of Tesla, but not all information. Why not? Because “all” information includes for example the current status of every Tesla vehicle. Why does that matter? Because if one causes an accident or catches on fire, people get a hissy fit online and it affects the stock price.
You would also need to know the exact psychology of every person buying and selling, and what is driving the decision to click on green or red at any given time. Since we can’t do that even for one person, because we don’t understand how the brain even works, and in this case, you don’t even know who else is trading. You just don’t know, and can’t know. Hence, price movements are mostly* random.
*Much like reading tea leaves for telling fortunes, there is a whole hobbyist movement around price patterns. Feel free to read up on your own time if you want to find more elaborate strategies to lose your savings even faster!
Let’s compare scenarios: Trade vs. Invest
Okay, say you have that $1,000 right now. Your options are A) either to day trade that now to get rich quick, or B) invest it and get rich really slowly. So clearly A wins, right? Well, let’s think about the probability for a moment.
Trading: Best to worst outcomes
Best case: How likely is it that you will be able to trade $1,000 into a million bucks? Do you personally know many who have done that? Do you know anyone? That one guy on Instagram? Yeah, it doesn’t happen. Remember 99% of traders lose. You’re just not going to be the exception. Sorry. Try the lottery instead?
Median case: There is a low probability, around 1% chance that you dedicate yourself to the craft, learn about markets, and can ultimately make a living by day trading. Those people do exist. They probably ride unicorns and hang out with leprechauns. But you have to ask yourself the question. Is that what you want to do with your life? Sit in front of screens looking at stock prices all day? Is there no contribution, skill, or passion you have that would make you more fulfilled and happy? Maybe something that involves other people?
Worst case: Then the most likely and worst outcome. So now you have zero dollars. At least you had fun. Oh, wait. You actually didn’t. It was extremely stressful, you sat in your basement in your sweatpants losing money. Maybe next time just go to Vegas instead? At least you might get a complimentary drink for your troubles.
Investing: Best to worst outcomes
Best case: Now let’s look at investing. Could you get super lucky and turn $1,000 into a million? Doubtful. The recent peak performance would be if you put that thousand in at the recent historical low in 2009, and you would now have $10,000. That’s pretty crazy to 10x in a decade, that doesn’t happen much historically. So don’t assume that will happen in the next decade. Although who knows, if Elon takes us to Mars we might see totally new levels of economic growth fueling the stock markets.
Median case: Slap that $1,000 into QQQ and wait 30 years. What do you get? Okay, not a million, but a lot. So what if you want a million? Well, consider this. What if you found a way to save $100 each month instead? Forget the $1,000, it makes no difference in the longterm. If you put aside $100 x 12 months x 30 years that’s $36,000. Which is not nothing, but also not a lot. Through the wonders of compound interest and time that could become a million dollars.
Worst case: Could you lose all your money? Yes, although it’s never happened in history if you invested in a major index like the S&P 500. That would mean that all large companies in America went bankrupt at the same time. If it did, then you probably have bigger problems like a nuclear apocalypse or alien invasion. The worst crashes and depressions in recorded history would set you back around 70%, but remember if you were investing for a while you would probably still be up a lot then! And if you start by dollar-cost averaging, meaning buying a little each month, it’s actually great news if there’s a depression and bear market because you get cheap stock that will go up later!
Moral of the story
There’s a reason “get rich quick” schemes get a bad rap because they don’t exist. What’s crazier is that people don’t see that there is a “get rich slowly” scheme that not only works but is actually very likely.
There’s a guy that has been doing just such a thing for 60 years. He’s 90 now. You may have heard of him, he’s Warren Buffet. There’s a reason guys like Bill Gates and Lebron James go to him for advice on money. Through just buying and not selling he made so much money it doesn’t really compute. Two million percent returns over 60 years. Just by giving his money to companies that knew what to do with it. As their businesses grew over the years and decades, that original money kept its value and then multiplied with the growth of the economy.
Of course, none of us are the “Oracle of Omaha” and we shouldn’t try to replicate his formula. He even says it himself all the time, that people should just buy the S&P 500 ETF and be done with it. You’re giving your money to the 500 most successful companies in America. That seems to be a good strategy for since counting started. Bill Ackman, another monster shark trader, has gone even further by recently stating that America should give every child $6,750 when they are born. Invested in index funds with an average return of 8% it would turn every child into a millionaire by the age of 65. No one would have to be poor again!
Yes, but how tho?
Okay so let’s imagine you bought the story. How do you actually do it?
- Stop thinking about returns and winning completely, it’s irrelevant. All you need to think about is how much you’re paying for someone to let you buy those stocks. That’s the only factor in your control, the rest isn’t.
- Find a cheap reputable online broker, where you know what you’re paying for. Buy a basket of index funds only, preferably high volume ETFs from household names like Blackrock, Vanguard, or Franklin Templeton. If you don’t want the hassle of choosing what to buy and when just find a reputable Robo-advisor that has been in business for years and has good reviews about customer support. They will take your monthly deposit and split that into a portfolio of low-cost index funds for you. If you want to go the extra mile, why not put a little of that money each month into some cryptocurrencies.
- Focus blindly about pouring as much money as you can afford each month into your investments. Think of your portfolio as a cave that you never look into but just throw a bag of coins into each month. Never sell. I do mean never. There should not even be a consideration of selling. Not until you’re done.
- When you sell its final, no going back. The absolute worst thing you can do is to get swept back into the game because a friend or news anchor said so. You will only lose what you worked hard for.
***Wait did you say free stocks?
Free stock trading, you say? Are people getting Apple and Tesla shares for free? No, quite the opposite in fact. You see, the way finance works is that the middleman always gets paid. Why do you need middlemen? Well, there’s a whole history in itself, but safe to say that money related business is highly regulated, so companies are given specific roles to play and report on their activities in excruciating detail. Partially to make sure regular people don’t get ripped off, but mostly to maintain the stability of the financial system that runs the world. If push comes to shove, you can bet it’s the retail investor who gets shafted, while banks get bailed out. Think 2009.
Oh right, the free stocks. Yes, well, when you buy a stock there are at least two companies you deal with, if not more. You need a broker that takes your orders, kind of like the waiter in a restaurant. You want to buy a stock, so you give the broker your order and your money. The broker takes your order and money to the exchange, kind of like a kitchen. There, your money is exchanged for the stock. But since printing out stock certificates is pretty slow and you might lose it, the stock is kept at a custodian instead. Kind of like a cash register. So if something goes wrong, the government knows exactly who to hit with a big stick.
Now traditionally the waiter gets paid. So does the exchange, and the custodian. After all, they are all offering you the ability to buy that stock you so crave. Isn’t it fair? Well, people don’t like to pay for anything anymore, and they perceive many things to be free. Like Facebook. Or Google. Both make billions selling ads directly to your amygdala. But it’s totally “free”. Similarly, there’s a trend for “free” stock trading, started ten years ago by a Silicon Valley startup called Robinhood.
The name conjures up an image of an honest, principled hero, that takes from the rich what they don’t really need, and brings it to the people. “Investing for Everyone” they say. Well, here’s how that really works. Think of the restaurant again. The waiter says they work for free, so you only pay for the food. Sounds fair. But wait… who pays the waiter’s salary? Do you care? What if they get a tip each time you buy food. But not from you, but a really fat guy in the kitchen. He pays the waiter a big salary because they steal some of your food. One french fry from you, a chicken nugget from the next guy. Every time.
Did I lose you yet? In stock trading terms, what happens is that Robinhood sells your order to another company. In effect, if you sent $100 to get some Tesla stock, you will only get back say $97 worth of Tesla stock. How? Just because the exact price you pay for a stock is determined by the broker and exchange together. There are rules that govern this type of thing. But as always, there are also loopholes. So the next time you buy a free stock just think of the fat guy in the kitchen munching your food, licking his greasy fingers.
Just scraps though, right? Well, given Robinhood has millions of customers, it’s more like the fat guy pays them $100,000,000,000 or more every year. Yeah, it adds up real quick. It’s more like Robinhood is in cahoots with the prince of Sherwood. Pretty sure that wasn’t in the Disney movie. How do they keep getting away with it? Well, they have gotten fined by the SEC before, and are being investigated again facing another $10M fine. But that’s chump change for them. Well, technically you’re the chump since they’re using your change.