SPECIALIZED DAY TRADING - A NEW VIEW ON AN OLD GAME

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1 August 7 - August 12, 2006 n Baden-Baden, Germany SPECIALIZED DAY TRADING - A NEW VIEW ON AN OLD GAME Vladmr Šmovć 1, and Vladmr Šmovć 2, PhD 1 Faculty of Electrcal Engneerng and Computng, Unska 3, Zagreb, Croata & Department of Mathematcs, Unversty of Zagreb, Bjenčka cesta 30, Zagreb, Croata, 2 Unversty of Zagreb, Faculty of Teacher Educaton, Sska cesta 77, Zagreb HR-10000, Croata, Abstract After the U.S market earned strong returns n 2003, day tradng made a comeback and once agan became a popular tradng method among traders. Although there s no comprehensve emprcal evdence alable to answer the queston do ndvdual day traders make money, there s a number of studes that pont out that only few are able to consstently earn profts suffcent to cover transacton costs and thus make money. The day tradng concept of buyng and sellng stocks on margn alone suggests that t s more rsky than the usual gong long way of makng proft. Ths paper offers a new approach to day tradng, an approach that elmnates some of the rsks of day tradng through specalzaton. The concept s that the trader should specalze hmself n just one (blue chp) stock and use exstng day tradng technques (trend followng, playng news, range tradng, scalpng, techncal analyss, coverng spreads ) to make money. Keywords: Day Tradng, Blue Chp 1. Introducton The name, day tradng, refers to a practce of buyng (sellng short) and sellng (buyng to cover) stocks durng the day n such manner, that at the end of the day there has been no net change n poston; a complete round trp trade has been made. A prmary motvaton of ths style of tradng s to od the rsks of radcal changes n prces that may occur f a stock s held overnght that could lead to large losses. Traders performng such round trp trades are called day traders. The U.S. Securtes and Exchange Commsson adopted a new term n the year 2000, pattern day trader, referrng to a customer who places four or more round-trp orders over a fve-day perod, provded the number of trades s more than sx percent n the account for the fve day perod. 1 There are four common technques used by day traders: trend followng, playng news, range tradng and scalpng. Playng news and trend followng are two technques that are prmarly n the realm of a day trader. When a trader s followng a trend, he assumes that the stock whch had been rsng wll contnue to rse, and vce versa. One could say he s actually followng the stocks 1 On February 27, 2001, the Securtes and Exchange Commsson (SEC) approved amendments to Natonal Assocaton of Securtes Dealers, Inc. (NASD ) Rule 2520 relatng to margn requrements for day traders. Under the approved amendments, a pattern day trader would be requred to mantan a mnmum equty of $25,000 at all tmes. If the account falls below the $25,000 requrement, the pattern day trader would not be permtted to day trade untl the account s restored. 49

2 August 7 - August 12, 2006 n Baden-Baden, Germany momentum. When a trader s playng news, hs basc strategy s to buy a stock whch has just announced good news, or sell short a stock whch has announced bad news. Fgure 1 NASDAQ 2 Composte quote data from 1997 to 2006 After ts boom durng the dotcom frenzy of the late 1990s and the loss n popularty after the Internet bubble burst, day tradng s makng a comeback. After three years of strong stock market performance, a constantly ncreasng number of nvestors use day tradng technques to make proft. A search on the Socal Scence Servce Network reports 395 artcles on day tradng, wth over 40% publshed n the last 3 years. A smlar search on the most popular onlne bookstore, Amazon 3 wll result n more than 400 popular books on day tradng. Many of the popular news agences and papers 4 report a surge n day tradng popularty whle some are also reportng ts negatve sdes. Searchng the most popular World Wde Web searchng engne, Google 5, for the term day tradng results n over 120,000,000 lnks. The frst one of those lnks redrects a user s browser to a warnng about rsks nvolved n day tradng publshed on the homepage of the U.S. Securtes and Exchange Commsson. 2 Natonal Assocaton of Securtes Dealers Automated Quotatons 3 Accordng to Alexa Traffc Rankngs, Amazon s the 15.th most popular ste and the hghest ranked onlne bookstore on the Top 500 ste rankng lst 4 Assocated Press reported a centrepece In Japan, day tradng surges n popularty on May 10, The Sunday Tmes publshed an artcle Hgh-rsk day tradng makes a comeback on February 26, Google s the most popular search engne accordng to the last Nelsen NetRatngs Search Engne Ratngs that were publshed n November of

3 August 7 - August 12, 2006 n Baden-Baden, Germany 2. The Controversy Fgure 2 - U.S. Securtes and Exchange Commsson warnng on day tradng The day tradng controversy s manly fuelled by ts man con, t s rsky. The constant usage of margn 6 s the strong and the weak pont of day tradng, because the usage of margn amplfes gans and losses such that substantal losses (and gans) may occur n a short perod of tme. Because day tradng mples a mnmum of two trades per busness day 7, a part of the day trader s funds are used to pay commssons 8. The hgher the number of trades per day s, the bgger the part of day trader s funds s used to pay commssons. Day tradng also often requres lve quotes whch are costly, and therefore also he an mpact on the funds of a day trader. For every one of these (man) cons, day tradng s, as t was already mentoned, consdered rsky. An ntegral part n the day tradng controversy s the day trader hmself. Clams of easy and fast profts from day tradng he attracted a sgnfcant number of non experenced and casual traders nto day tradng that do not fully understand the rsks they are takng. Wth ts latest comeback, day tradng has become a busness to people other than traders. Numerous webstes offer tps and advces whle onlne bookstores offer books on day tradng strateges. 6 borrowed funds 7 buyng (sellng short) and sellng (buyng to cover) 8 the broker's basc fee for purchasng or sellng securtes as an agent 51

4 August 7 - August 12, 2006 n Baden-Baden, Germany Fgure 3 - U.S. Securtes and Exchange Commsson warnng on day tradng nfo Wth all that n mnd, one could wonder do day traders make money. Although that queston can not be answered wth certanty, a few exstng studes do not pant a pretty pcture. A comprehensve analyss of the proftablty of all day tradng actvty n Tawan over a fve year perod 9 has shown that n a typcal sx month perod, more than eght out of ten day traders loose money. 3. Specalzed Day Tradng 3.1 The Concept The man goal of Specalzed Day Tradng s to offer a new approach to day tradng, an approach that would dampen or elmnate some of the negatve sdes of regular day tradng. The concept s smple. Instead of usng the usual day tradng technques on varous types of stocks, the trader should specalze hmself n usng the same, already mentoned technques, but wth just one (blue chp 10 ) stock. 3.2 Specalzaton The man reason why specalzaton s proposed s n the fact that tradng wth dfferent stocks on a daly bass brngs a certan element of uncertanty snce the day trader often does not he the tme to thoroughly check up on a stock he s tradng wth. Focusng on just one stock elmnates the element of uncertanty and gves the day trader the opportunty, to through tme better learn about ts behour and how the selected stock reacts to certan events lke splts, earnng announcements, general (good or bad) news etc. Through constant montorng, a trader could gan knowledge on how the stock reacts on markets ups and downs, better nsght on the meanng of after hours tradng actvty or the manner how the company releases announcements (do worse announcements get announced on Frday to dampen the short-term response of the trader and thus the market? 11 ) etc. 9 Do Day Traders Make Money? Brad M. Barber, Y-Tsung Lee, Yu-Jane Lu, Terrance Odean (January 2005) 10 A blue chp stock s the stock of a well-establshed company hng stable earnngs and no extensve labltes. 11 Strategc Release of Informaton on Frday: Evdence from Earnngs Announcements, Stefano Della Vgna, Joshua Pollet (January 2005) 52

5 August 7 - August 12, 2006 n Baden-Baden, Germany 3.3 Blue Chp The focus was put on blue chp stocks because they offer stablty, whch of course translates nto low rsk. Wth day tradng blue chp stocks one can not expect great proft n a sngle day, but the trade-off s that one can not expect great loss also. For further analyss of behour of the blue chp stocks, we ve taken Mcrosoft as an example. Ttle: Open Close spread % 4,5 4 3,5 3 spread [%] 2,5 2 1,5 1 0, workng days daly spread erage spread Fgure 4 a graph showng the spread between the openng and the closng prce The analyss was based on 3 years (756 workng days) of daly data 12 (from 07/18/2003 tll 07/18/2006). That partcular perod of tme was chosen for our analyss because t conssts of newest daly quotes from the last MSFT 13 stock splt (02/18/2003). The data s conssted of the openng prce ( o ), closng prce ( c ), daly low ( l ) and the daly hgh ( h ). Usng the followng equatons we ve calculated the values (percentage) of the daly spreads ( S ) between the openng and the closng prce. Ths was done n order to calculate the erage spread ( S ) between the two already mentoned values whch wll help us llustrate the potental of ths knd of day tradng. 12 The data was obtaned on Nasdaq s webste 13 Symbol that represents a Mcrosoft stock 53

6 August 7 - August 12, 2006 n Baden-Baden, Germany c o o 100 = S = S n S =1 [ 1, n] n n = 756 The erage spread between the openng and the closng prce ( S ) for a Mcrosoft stock n that perod of tme was 0, % whch s a very good ndcator of ts stablty. Usng the exact equatons we ve also calculated the values (percentage) of the daly spreads ( Q ) between the daly low and the daly hgh. Ths was done n order to calculate the erage spread ( Q ) between those two values so that we can llustrate the full (but unreachable) potental of ths knd of day tradng. h l l 100 = Q = Q n Q =1 [ 1, n] n n = 756 The erage spread between the daly low and the daly hgh ( Q ) for a Mcrosoft stock n that perod of tme was 1, %. Ttle: Low Hgh spread % spread [%] workng days daly spread erage spread Fgure 5 - a graph showng the spread between the daly low and the daly hgh 54

7 August 7 - August 12, 2006 n Baden-Baden, Germany 2.4 The Potental To show the potental proft for ths way of day tradng we are gong to use the followng functons wth the already calculated erage daly spreads. These functons represent the total return (va percentage) n 30 workng days of whch a certan number (α) had a postve (and the rest negatve ) tradng outcome. S Q α α S Q α 30 α 100 = S 100 = Q p p Ttle:Total return by days % return [%] "postve" days open close return low hgh return Fgure 6 - a graph showng the spread between the daly low and the daly hgh wthout the usage of margn Wth the usage of margn (M), gans and losses are amplfed. S M α S M α 100 = S mp 55

8 August 7 - August 12, 2006 n Baden-Baden, Germany Q M α Q M α 100 = Q mp Ttle: Total return by days wth the usage of margn (*1.5) % return [%] "postve days" open close return low hgh return Fgure 6 - a graph showng the spread between the daly low and the daly hgh wth the usage of margn 4. Concluson Through Specalzed Day Tradng, we ve tred to offers a new approach to day tradng and wth t elmnate some of the rsks of day tradng. The paper tred to explan the reasons behnd the concept of specalzaton n tradng n just one (blue chp) stock wth the usage of exstng day tradng technques and show that the usage of such concept has potental and can be proftable. 5. References [1] Juhan Lnnanmaa (June 2003), The Anatomy of Day Traders [2] Brad M. Barber, Y-Tsung Lee, Yu-Jane Lu, Terrance Odean (January 2005), Do Day traders Make Money? [3] Stefano Della Vgna, Joshua Pollet (Januarty 2005), Strategc Release of Informaton on Frday: Evdence from Earnngs Announcements [4] 56

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