The Secret Lives of Day Traders

Sociologist Mitchel Abolafia, who studied bond markets in the 80s, coined the phrase “cycle of opportunism” to describe the rise and fall of the tolerance for guile within a given market. Markets aren’t shaped by rational economic expectations alone, as economists model them, but also by the self-images of their participating members.

Gregory J. Millman’s useful account of the recent emergence of day trading and Mark Friedfertig and George West’s interviews with 13 traders provide real-life insight into Abolafia’s theory. While the useful stimulus provided by the SEC has certainly helped to break the cartel-like power of the market makers, there is surely something very American about day traders — the penchant for the frontier.

Millman provides a glossary of day trading terms, a history of day trading, a lively journalistic foray into the culture of day trading, and last but, alas, least, dissection of the phenomena. As an analyst, Millman is not entirely coherent, especially evident in his cursory chapters about Europe. He also has an irritating penchant for grandiose rhetoric like “extreme investment.” Otherwise, Millman is a good journalist, and explains the basics of the day trading revolution without getting bogging down in technicalities.

Three factors, in his account, converged to produce the present day trading business:

1) The invention of real-time electronic communication networks (ECNs), such as Instinet, Island, and Archipelago

2) New rules imposed by the SEC eliminated barriers to both the free dissemination of price information and the collusive practice of market makers inflating spreads

3) The opening up of ECN access to small traders

ECNs date back to 1971, before many of today’s star traders were born — which puts the new rules in perspective. Bill Lupien, working for the Pacific Exchange at the time, witnessed a demonstration of Instinet and immediately apprehended its usefulness. Back in the 70s, bids and orders still traveled haltingly over phone and by hand until they reached the floor of the exchange. Instinet allowed traders to hit bids and make offers instantly. Still, access to Instinet was restricted to big traders, and exchange rules overwhelmingly favored these traders.

In 1984, the Small Order Execution System (SOES) was put into effect on the big exchanges. In theory, this leveled the playing field between small and big traders, but, as the crash of October, 1987, showed, this wasn’t true in practice. Market makers simply disconnected from the SOES.

Breaking the hold of the market makers took the energy of SOES “bandits” like Harvey Houtkin, the unlikely rebel to whom Millman devotes his first chapter. Houtkin, a flamboyant Brooklyn trader, took on the National Association of Securities Dealers and won the right for outside traders to participate in the market, via the SOES. However, it wasn’t until 1996, when two economists proved that market makers and Nasdaq were colluding to maintain wide price spreads, that the SEC enacted new order handling rules. Price quotes had been quoted in fourths for the general public, while market makers were dealing in eighths. Even the most talented day trader wouldn’t have been able to make money paying $5-1/4 for a stock that costs a competitor $5-1/8

A moral impetus comes with “democratizing” the market. The cycle of opportunism can be traced from Houtkin’s victories in the mid-nineties, when day traders struck gold and were mistakenly viewed as populists, to the present, when the real money is made by the proprietors of day trader brokerage houses. These brokers, who charge commissions on every transaction, form a demimonde of their own, as illustrated by the Dickensian tale of Houston-based Block Trading. Jeff Burke took care of Block’s PR, attracting customers with Get Rich Quick lingo. Every morning, the company faxed a list of the clients who had margin calls due to Burke’s father, a kindly doctor type specializing in “addiction.” The good doctor would loan money to the clients, at an annualized rate of about 36 percent. The company was eventually taken to court, where it was revealed that about ninety percent of the clientele lost money. Millman believes this figure is about the norm around the country.

Friedfertig and West talk to the other ten percent, almost all of whom have business degrees and finance experience. This unexceptional fact should counter the media myth that day traders are untrained outsiders, a sort of children’s crusade come to Wall Street. The “secrets” in the title are, of course, a come-on — not one has a magic formula. At most, these day traders have developed ad hoc psychological strategies tailored to their own particular quirks, with a few rules of thumb. Traders generally make money on the patterns produced by the price movement of stocks. One of the stars, Serge Milman, gives an example of a trade in FAMCK, freely admitting he doesn’t know the company behind the ticker. He cares about the price levels.

“About ninety percent of the day trader’s clientele lost money. Millman believes this figure is about the norm around the country.”

Day traders are generally unconcerned with fundamentals. Knowing them can actually be a hindrance, convincing the trader he knows better than the market, a common error which can leads to bankruptcy. They are playing the levels. Traders also have to learn how to cut loose from bad trades. Because of the speed of the trades, large amounts of money can disappear if a wrong guess about price movement isn’t corrected.

Interestingly, the traders profiled in both books show an exaggerated sense of solitude. Almost all of Millman’s stories of middle aged people trying to make it as day traders involve family breakups or other personal disaster. Younger people seem to be disengaged from the norms of family or social life. Abolafia, in the eighties, came across the same lifestyle individualism among junk bond traders. This just might be the sociological “secret” of day trading.

Both books discuss the future of the business. Most of the good day traders are confident that a bear market won’t shake them out. What might impact the industry, however, is tightening money, making it much more difficult to borrow for margin calls. Additionally, a  new ECN in the works called Optimark will mask big trading transactions from the small trader. Who invented it? Bill Lupien himself, who helped invent day trading in the first place.

The Day Traders: The Untold Story of the Extreme Investors and How they Changed Wall Street Forever by Gregory J. Millman

and

Electronic Day Traders’ Secrets: Learn From the Best of the Best DayTraders by Mark Friedfertig and George West

(Times Business and McGraw Hill ISBNs: 0-8129-3186-6  and 0-07-134767-4)