Some Friendly Reminders About Day Trading

The Wall Street Journal profiled a GameStop day-trader who turned $500 into more than $200k:

Anubhav Guha started day trading a few thousand dollars in March but managed to lose half of his money despite the stock market’s epic rally last year. He made that up and far, far more betting on GameStop Corp. GME

Mr. Guha turned $500 into $203,411 in less than three weeks with an options trade on the mall retailer.

Good for him. This is a life-changing amount of money for a grad student.

And good for him he has a solid group of friends too:

“You really need to sell,” a friend said.

He wouldn’t. Some on Wall Street Bets were predicting GameStop would hit $1,000, even $5,000. Hold tight and don’t sell, they urged. We’re in this together.

Finally, his friends staged what Mr. Guha jokingly calls a “mini intervention.” One asked if he would invest in GameStop at the sky-high levels if he had fresh money—if not, he should exit the trade. The argument won him over.

GameStop crashed as much as 90% this week so it’s a good thing he sold.

There have been plenty of stories about huge wins and huge losses in recent months for day-traders. Many of the early adopters in some of the stocks that went vertical made out like bandits. Others were left holding the bag.

There will always be winners and losers in the stock market, even for those who aren’t day-trading. This is simply the zero-sum nature of transacting in a market like this. For every buyer, there has to be a seller and vice versa.

But day-traders face a much higher hurdle rate than long-term investors for a couple of reasons:

Day trading is hard. I know, I know, no one likes to hear about the pitfalls of day-trading when it seems so fun and lucrative. But I would be remiss if I didn’t share some statistics as a cautionary tale for those who feel like they’re earning easy money trading stocks right now and assume it will always be like this.

A study of Brazilian futures traders found 97% of individuals who traded in the market for more than 300 days lost money on their trades.

Research on individual day traders in Taiwan over a 15 year period from 1992 to 2006 showed even the most experienced day traders lose money and surprisingly even those traders who lose consistently continue to trade despite their losses.

The SEC studied the habits of retail FX traders and discovered, “approximately 70% of customers lose money every quarter and on average 100% of a retail customer’s investment is lost in less than 12 months.”

Another study of eToro day-traders found nearly 80% of them lost money over a 12-month period with a median loss of 36%.

Are there people who can become successful day-traders? Of course.

Are the odds in your favor? Nope.

The only guarantee when day-trading is taxes. I’m sure some people are trading in tax-deferred accounts but not at Robinhood. All Robinhood accounts are taxable at the moment. And adding taxes to the mix increases your hurdle rate substantially since short-term gains are taxed at a higher rate than long-term gains.

The Journal had another story this week reminding Robinhood trader about the IRS. I have a feeling many of the new traders are in for a rude awakening when they get their tax bill:

Joseph Holler started day-trading stocks last July when he was stuck at home during the pandemic and his work slowed down.

“It was fun and exciting. I enjoyed it,” says Mr. Holler, a 38-year-old telecom salesman who lives near Huntsville, Ala., with his wife and their five children. Using several no-commission online brokers, he sometimes made more than 200 trades a day and thousands in 2020, according to brokerage records he provided. Overall, he says, he’s ahead by more than $8,000.

Now this fun will be put to the test by Uncle Sam: This week Mr. Holler received his first tax document, a 1099 form detailing a small portion of his trades. It’s 34 pages long.

“It’s so convoluted, I have no idea what it means,” says Mr. Holler, who has always prepared his own taxes using software. With hundreds more pages of records coming, he thinks he’ll need to hire a professional preparer this year.

Here’s another one:

Carlos Diaz, a 23-year-old software salesman based in Atlanta, says his $3,000 account is up more than 30% in the past year. But he says he’s only starting to learn about how losses can offset gains and the timing issues that come into play.

“I’ve heard that taxes affect the bottom line, and I want to know more,” he adds.

Outperforming the market is hard enough as it is without taking into consideration taxes on short-term gains. I’m guessing many Robinhood traders don’t know or don’t care how they’re doing in relation to the overall market but they will probably start to care if and when they get hit with a big tax bill.

To be fair, paying taxes on your investments is a good thing — it means you have gains which is better than the alternative.

Unfortunately, many day-traders could be looking at a situation where they traded their faces off in 2020 with exceptional results but have lost a huge chunk of change in the GameStop carnage of early-2021, making it harder to pay their tax bills this spring. A similar dynamic played out in the crypto bubble of 2017 which was reversed the following year.

I’m not here to tell anyone how to invest their money. People are free to trade as much or as little as they please. And many of these traders are doing it on the side with speculative money.

But make sure you go into this with your eyes wide open with the understanding that day-trading is hard and it generally comes with a higher tax bill than a long-term buy and hold strategy.

Further Reading:
How the Stock Market Works

 
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