One method of making money in the stock market is day trading. Day trading rose in popularity in the late 1990s when investors could double or even triple their gains within a matter of hours. With returns like this, it was hard to resist the temptation of becoming a day trader yourself.
In this day and age, you do not get the returns that you could have gotten in the 90s, but the temptation to day trade is still there. Markets have been booming ever since the Great Recession. Since the market bottomed out in 2009, the S&P 500 has returned 172% and the Dow Jones Industrial Average has returned 131%. Due to the increase in markets at such a rapid rate, investors today have been able to day trade and achieve solid results.
As a matter of fact, I just recently read an article on a 16 year old who began day trading and had thus far achieved decent results. In 2012 her stocks returned over 34% vs the S&P 500 which only returned 12%. While it is not impossible to achieve those results, it is hard to maintain such rapid rate over a long sustainable time period.
Jason Zweig discussed the topic of day trading in his commentary to The Intelligent Investor. He discussed that while some trades make money and some trades lose money, your broker will always make money. In addition, he goes into detail about the true cost of trading over such short time periods.
The Costs of Day Trading
- Your own eagerness to buy and sell stock will lower your return. Zweig call this cost “market impact.” While this cost doesn’t show up on any of your statements, it can cause you great losses. Let’s say you are eager to buy a stock, and you end up paying an extra 10 cents per share to get it. If you buy 500 shares of that stock, you just cost yourself $50. On the flipside, if you sell the stock too soon, you can also lose out on significant gains.
- Brokerage fees eat into gains. Many brokers will charge you anywhere from $4 to $9 to make a trade, no matter how many stocks you purchase. Assuming you pay $7 per trade, you will pay a total of $14 to buy and subsequently sell a stock. If you purchase $1000 worth of stock, this will eat into 1.4% of any gains you make.
- Taxes, taxes, taxes. When you buy and sell your stocks frequently, taxes can eat into your gains significantly. Any gains you make on stocks you sold within a year are taxed at your ordinary income rate, which could be up to 39.6%. Compare that to the maximum rate of 20% you pay for gains for stocks held on to for over a year, and you could be paying significantly more in taxes.
Zweig also cites a study done by professors of Finance Brad Barber and Terrance Oden at the University of California. In this study, the professors studied 66,465 households with accounts at large discount brokers from 1991 to 1996. What they found was those that traded the most (portfolio turnover of 21.5% a month) had an average return of 11.4% vs a return of 18.7% for those who had the lowest turnover (portfolio turnover of 0.19% a month). In addition, those who had the lowest turnover actually had a slightly better return than the market average. The chart below shows a visual representation of this study.
Have you ever day traded? What are your experience with day trading? Please leave a comment below. I’m interested to hear your opinion.